Cost Volume Profit Analysis

CVP Analysis helps answer questions like -

• Why can airlines upgrade passengers to first class without additional
charge once the gates have closed and the flight has taken off?
• Why would resorts offer significant discounts (50% or more) on room
rates during off-peak season?
• Why would printing businesses require a minimum number before
accepting an order?
• Why are there restos that would choose to have their own delivery
personnel while others rely on services like GrabFood or FoodPanda?
Pricing Promos Based on Understanding of
Cost Behavior
Important Concepts
• Classifications of cost based on behavior
• Contribution margin
• Contribution format income statement
• Break even
• Margin of safety
• Operating leverage
Illustrative Example
MJ sells home-made donuts at a kiosk in a school. Each donut sells fo
P24 and has a variable cost of P18. MJ’s monthly fixed costs are
P24,000. On average, MJ sells 5,000 donuts per month.
He was offered to open an outlet in another, slightly smaller, school. His
costs will remain roughly the same.
Construct a CVP graph for MJ to help him decide whether or not to
open a second outlet. Identify the profit he makes at his average
volume of 5,000 units, and his breakeven point.
Cost Structure and Profit Stability
Cost structure refers to the relative
proportion of fixed and variable costs in an
organization. Managers often have some
latitude in determining their organization’s
cost structure.
 Cost Structure and Profit Stability –
High and Low Fixed
Cost Structures
There are advantages and disadvantages to high fixed cost
(or low variable cost) and low fixed cost (or high variable
cost) structures.
An advantage of a high fixed
cost structure is that income A disadvantage of a high fixed
will be higher in good years cost structure is that income
compared to companies will be lower in bad years
with lower proportion of compared to companies
fixed costs. with lower proportion of
fixed costs.
Companies with low fixed cost structures enjoy greater
stability in income across good and bad years.
 Operating Leverage
Operating leverage is a measure of how
sensitive net operating income is to percentage
changes in sales. It is a measure, at any given
level of sales, of how a percentage change in
sales volume will affect profits.

Degree of Contribution margin

operating leverage = Net operating income
Operating Leverage - Example
To illustrate, observe the contribution income
statement for RBC.
Actual sales
500 Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income $ 20,000

Degree of
Operating $100,000
= $20,000 = 5
Leverage
 Operating Leverage – Changes in Profit
With an operating leverage of 5, if RBC increases its sales by 10%, net
operating income would increase by 50%.

Percent increase in sales 10%

Degree of operating leverage × 5
Percent increase in profits 50%

Here’s the verification!

 Operating Leverage –
Proof of Changes
Actual sales Increased
(500) sales (550)
Sales $ 250,000 $ 275,000
Less variable expenses 150,000 165,000
Contribution margin 100,000 110,000
Less fixed expenses 80,000 80,000
Net operating income $ 20,000 $ 30,000

10% increase in sales from

$250,000 to $275,000 . . .

. . . results in a 50% increase in

income from $20,000 to $30,000.
 Quick Check
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is $0.36.
The average fixed expense per month is $1,300. An
average of 2,100 cups are sold each month. What is the
operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92
Operating Leverage
A B
Selling price 300 300
Variable cost 120 220
Contribution
margin 180 80
Fixed costs 250,000 100,000

BA 115 Management Accounting (Valderrama) 13

Operating Leverage
Operating Leverage
700000

600000

500000

400000

300000

200000

100000

0
500 750 1000 1250 1500 1750 2000

Revenues Total cost (A) Total cost (B)

BA 115 Management Accounting (Valderrama) 14

https://www.theguardian.com/business/2016/sep/02/hanjin-shipping-bankruptcy-causes-turmoil-in-global-
sea-freight

BA 115 Management Accounting (Valderrama) 15

By Sherisse Pham, CNN Business
Updated 1258 GMT (2058 HKT) October 8, 2019

BA 115 Management Accounting (Valderrama) 16

Handling Mixed Costs (Ch 6 Appendix)
Assume the following hours of maintenance work
and the total maintenance costs for six months.

Total Maintenance
Month Hours of Maintenance
Cost
January 625 $ 7,950
February 450 7,400
March 700 8,275
April 550 7,625
May 775 9,100
June 850 9,800
Scattergraph Plot
Plot the data points on a graph (Total Cost Y,
dependent variable versus Activity X,
independent variable).
Mixed Costs Formula
Mixed cost line can be expressed as an equation:
Y = a + bX
Where:
Y = The total mixed cost
a = The total fixed cost (the vertical intercept of the line)
b = The variable cost per unit of activity (the slope of the
line)
X = The level of activity
The High-Low Method – Select High and
Low Values
Month Hours of Maintenance Total Maintenance Cost

January 625 $ 7,950

February 450 7,400
March 700 8,275
April 550 7,625
May 775 9,100
June 850 9,800
High 850 $ 9,800
Low 450 7,400
Change 400 $ 2,400
The High-Low Method – Select High and
Low Values: Formula
The variable cost per hour of maintenance
is equal to the change in cost divided by the
change in hours.

$2,400
= $6.00/hour
400
The High-Low Method – Fixed Cost

Month Hours of Maintenance Total Maintenance Cost

High 850 $ 9,800
Low 450 7,400
Change 400 $ 2,400

Total Fixed Cost = Total Cost − Total Variable Cost

Total Fixed Cost = $9,800 − ($6/hour × 850 hours)
Total Fixed Cost = $9,800 − $5,100
Total Fixed Cost = $4,700
The High-Low Method – Calculation

Month Hours of Maintenance Total Maintenance Cost

High 850 $ 9,800
Low 450 7,400
Change 400 $ 2,400

The Cost Equation for Maintenance

Y = $4,700 + $6.00X
Concept Check
Sales salaries and commissions are $10,000
when 80,000 units are sold, and $14,000
when 120,000 units are sold. Using the high-
low method, what is the variable portion of
sales salaries and commission?
A. $0.08 per unit
B. $0.10 per unit
C. $0.12 per unit
D. $0.125 per unit
Concept Check 2
Sales salaries and commissions are $10,000 when
80,000 units are sold, and $14,000 when 120,000 units
are sold. Using the high-low method, what is the fixed
portion of sales salaries and commissions?
A. $2,000
B. $4,000
C. $10,000
D. $12,000