STRATEGIC COST MANAGEMENT
Chapter 1: Cost-Volume-Profit Analysis
Cost-Volume-Profit (CVP) Analysis and Break-Even Point
 CVP analysis emphasizes the interrelationships of costs, quantity sold, and price.
It reconciles the financial information of the firm.
 Break-even point: Point of zero profit. There are two types of approach to find
the break-even point: (1) Operating income approach and (2) Contribution
margin approach.
Steps in Implementing Units-sold Approach to CVP Analysis
1. Determine what a unit is
2. Separate costs into fixed and variable components
o CVP focuses on the firm as a whole and all costs of the company are taken
into account.
Basic Concepts for CVP Analysis
 Variable product cost per unit = Direct materials + Direct labor + Variable
overhead
 Variable cost per unit = Direct materials + Direct labor + Variable overhead +
Variable selling expense
 Contribution margin per unit = Price − Variable cost per unit
 Contribution margin ratio = Contribution margin / Sales
 Contribution-margin-based operating income statement — a useful tool for
organizing the firm’s costs into fixed and variable categories.
 Operating income – income before income taxes
 Net income – operating income minus income taxes
Equation Method for Break-Even and Target Income
 Equation for a target profit put in terms of units
Units for a target profit = (Total fixed cost + target income) / (Price – Variable
cost per unit)
 Break-even equation when target income is zero
Break-even units = (Total fixed cost) / (Price – Variable cost per unit)
Contribution Margin Approach
 Total contribution margin equals the fixed expenses at break-even.
 Contribution margin: Sales revenue minus total variable costs
 Number of units = Fixed costs / Contribution margin per unit
Break Even Point and Target Income in Sales Revenue
 Units-sold measure can be converted to a sales-revenue measure by multiplying
the unit sales price by the units sold
 To calculate the break-even point in sales revenue, variable costs are defined as a
percentage of sales
 Variable cost ratio should be computed to express variable cost in terms of sales
revenue
 Variable cost ratio – Proportion of each sales dollar that must be used to cover
variable costs
 Contribution margin ratio – Proportion of each sales dollar available to cover
fixed costs and provide for profit
 Sales-revenue approach
Sales = (Total fixed costs + Operating income) / Contribution margin ratio
 At break even, operating income equals zero
Break-even sales = Total fixed costs / Contribution margin ratio
 Note: Income taxes do not affect the break-even point at all. Since taxes are a
percentage of income, zero income will generate zero taxes. However, CVP
analysis is affected by income taxes in that a target profit must be figured in
before-tax income since the CVP equations do not include the income tax rate.
Direct and Common Fixed Expenses
 Direct fixed expenses: Fixed costs that can be traced to each segment; would be
avoided if the segment did not exist.
 Common fixed expenses: Fixed costs that are not traceable to the segments;
would remain even if one of the segments was eliminated.
Break-Even Point in Units for the Multiple-Product Setting
 Multiple-product analysis requires the expected sales mix
o Sales mix – relative combination of products being sold by a firm,
o Defining sales mix allows one to convert a multiple-product problem to a
single-product CVP format.
Break-Even Point in Sales Revenue
 Uses the assumed sales mix
 Avoids the requirement of building a package contribution margin
 Computational effort is similar to that used in the single-product setting
 Note: A change in sales mix will change the contribution margin of the package
(defined by the sales mix) and, thus, will change the units needed to break even.
Profit-Volume Graph
 Portrays the relationship between profits and sales volume
 Graph of the operating income equation
 Operating income = (Price × Units) − (Unit variable cost × Units) − Fixed Costs
 Operating income is the dependent variable while the number of units is the
independent variable.
Cost-Volume-Profit Graph
 Depicts relationships among cost, volume, and profits
 To obtain more detailed relationships, it is necessary to graph the total revenue
line and the total cost line
Assumptions of Cost-Volume-Profit Analysis
 Linear revenue function and a linear cost function
 What is produced is sold
 Price, total fixed costs, and unit variable costs can be accurately identified and
remain constant over the relevant range
 For multiple-product analysis, the sales mix is assumed to be known
 Selling price and costs are assumed to be known with certainty
 Note: Packages of products, based on the expected sales mix, are defined as a
single product. Price and cost information for this package can then be used to
carry out CVP analysis.
Risk and Uncertainty in CVP Analysis
 Ways in which managers deal with risk and uncertainty
o Realize the uncertain nature of future prices, costs, and quantities
o Consider a break-even band instead of a break-even point
o Engage in sensitivity or what-if analysis
 Concepts used to measure risk
 Margin of safety – units sold or expected to be sold or revenue earned or
expected to be earned above the break-even volume. If a firm’s margin of
safety is large given the expected sales for the coming year, the risk of
suffering losses is less.
 Margin of safety (units) = units sold - units to break even
 Margin of safety (sales revenue) = MOS in units x selling price
 Operating leverage – use of fixed costs to extract higher percentage changes
in profits as sales activity changes. The greater the degree of operating
leverage, the more that changes in sales activity will affect profits. Mix of
costs that an organization chooses can have a considerable influence on its
operating risk and profit level.
 Degree of operating leverage = Total contribution margin / Profit
Sensitivity Analysis and CVP
 Sensitivity analysis – what-if technique that examines the impact of changes in
underlying assumptions on an answer.
 One can input data and set up formulas to calculate break-even points and
expected profits. Data can be varied as desired to see what impact changes have
on the expected profit.
CVP Analysis and Non-Unit Cost Drivers
 CVP can be modified to take in account costs that vary with non-unit cost drivers.
 Modification helps provide accurate insights concerning cost behavior.
 Note: All Activity-based costing reminds managers that costs may vary with
respect to unit and non-unit variables, such as the number of batches or number
of products. This insight prevents a single-minded focus on unit-based costs, to
the exclusion of factors which might change fixed costs.
CVP Analysis in Nonprofit Entities
 CVP analysis is helpful in not-for-profit entities.
 Managers should be aware of the different types of costs, the different drivers,
and the underlying economic conditions that affect them.