PROFIT PLANNING

Cost-Volume-Profit Analysis
and
Decision Making

3-1
Understand the assumptions
underlying cost-volume-profit
(CVP) analysis.

3-2
 Cost-Volume-Profit Assumptions
and Terminology

1. Changes in the level of revenues and costs arise

only because of changes in the number of product
(or service) units produced and sold.
2. Total costs can be divided into a fixed component
and a component that is variable with respect to
the level of output.

3-3
 Cost-Volume-Profit Assumptions
and Terminology

3. When graphed, the behavior of total revenues

and total costs is linear (straight-line) in relation
to output units within the relevant range
(and time period).

4. The unit selling price, unit variable costs, and

fixed costs are known and constant.

3-4
5. The analysis either covers a single product or
assumes that the sales mix when multiple
products are sold will remain constant as the
level of total units sold changes.

6. All revenues and costs can be added and

compared without taking into account the time
value of money.

3-5
 Components of CVP Analysis

*Level or volume of activity

*Unit selling Prices
*Variable cost per unit
*Total fixed cost

Sales – Variables cost – Fixed Cost = Income

3-6
Explain the features
of CVP analysis.

3-7
 Essentials of Cost-Volume-Profit
(CVP) Analysis Example

Assume that the Pants Shop can purchase pants

for $32 from a local factory; other variable costs
amount to $10 per unit.

The average selling price per pair of pants is $70

and total fixed costs amount to $84,000.

3-8
How much revenue will the business receive if
2,500 units are sold?

2,500 × $70 = $175,000

How much variable costs will the business incur?
2,500 × $42 = $105,000
$175,000 – 105,000 – 84,000 = ($14,000)
3-9
 What is the contribution margin per unit?
$70 – $42 = $28 contribution margin per unit
What is the total contribution margin when
2,500 pairs of pants are sold?
2,500 × $28 = $70,000

3 - 10
Essentials of Cost-Volume-Profit
(CVP) Analysis Example

Contribution margin percentage (contribution

margin ratio) is the contribution margin per
unit divided by the selling price.
What is the contribution margin percentage?
$28 ÷ $70 = 40%

3 - 11
If the business sells 3,000 pairs of pants,
revenues will be $210,000 and contribution
margin would equal 40% × $210,000 = $84,000.

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3 - 12
Determine the breakeven point
and output level needed to achieve
a target operating income using
the equation, contribution margin,
and graph methods.

3 - 13
 Breakeven Point

Sales – Variable
expenses =
Fixed
expenses

Total revenues = Total costs

3 - 14
 Abbreviations

SP = Selling price
VCU = Variable cost per unit
CMU = Contribution margin per unit
CM% = Contribution margin percentage
FC = Fixed costs

3 - 15
 Abbreviations

Q = Quantity of output units sold

(and manufactured)
OI = Operating income
TOI = Target operating income
TNI = Target net income

3 - 16
 Equation Method

(Selling price × Quantity sold) – (Variable unit cost

× Quantity sold) – Fixed costs = Operating income
Let Q = number of units to be sold to break even
$70Q – $42Q – $84,000 = 0
$28Q = $84,000
Q = $84,000 ÷ $28 = 3,000 units

3 - 17
Contribution Margin Method

$84,000 ÷ $28 = 3,000 units

$84,000 ÷ 40% = $210,000

3 - 18
 Graph Method

Breakeven
378
336
294
252
$(000)

210
168
126
84 Fixed costs
42
0
0 1000 2000 3000 4000 5000
Units
3 - 19
 Target Profit

(Fixed costs + Target profit)

divided either by Contribution margin
percentage or Contribution margin per unit

3 - 20
 Target Profit

Assume that management wants to have an

operating income of $14,000.

How many pairs of pants must be sold?

($84,000 + $14,000) ÷ $28 = 3,500
What dollar sales are needed to achieve this income?
($84,000 + $14,000) ÷ 40% = $245,000

3 - 21
 Understand how income
taxes affect CVP analysis.

3 - 22
 Target Net Income
and Income Taxes Example

Management would like to earn

an after tax income of $35,711.
The tax rate is 30%.
What is the target net income?
Target net income
= aftertax income÷ (1 – tax rate)
TOI = $35,711 ÷ (1 – 0.30) = $51,016
3 - 23
 Target Net Income
and Income Taxes Example

How many units must be sold?

Fixed cost + after tax profit
1-tax rate
divide
Contribution margin unit

Q = 84,000+ 51,016 ÷ $28 = 4,822 pairs of pants

3 - 24
 Target Net Income
and Income Taxes Example

Proof:
Revenues: 4,822 × $70 $337,540
Variable costs: 4,822 × $42 202,524
Contribution margin $135,016
Fixed costs 84,000
Operating income 51,016
Income taxes: $51,016 × 30% 15,305
Net income $ 35,711

3 - 25
 Explain CVP analysis
in decision making and
how sensitivity analysis helps
managers cope with uncertainty.

3 - 26
Using CVP Analysis Example

Suppose the management anticipates

selling 3,200 pairs of pants.
Management is considering an advertising
campaign that would cost $10,000.

It is anticipated that the advertising will

increase sales to 4,000 units.
Should the business advertise?
3 - 27
 Using CVP Analysis Example

3,200 pairs of pants sold with no advertising:

Contribution margin $89,600
Fixed costs 84,000
Operating income $ 5,600
4,000 pairs of pants sold with advertising:
Contribution margin $112,000
Fixed costs 94,000
Operating income $ 18,000
3 - 28
Additional sales required:

10,000/28
= 357 units.
 Operating Leverage

Operating leverage describes the effects that

fixed costs have on changes in operating
income as changes occur in units sold.
Organizations with a high proportion of fixed
costs have high operating leverage.

3 - 30
 Operating Leverage Example

Degree of operating leverage

= Contribution margin ÷ Profit
What is the degree of operating leverage
of the Pants Shop at the 3,500 sales level
under both arrangements?
Existing arrangement:
3,500 × $28 = $98,000 contribution margin
3 - 31
 Operating Leverage Example

$98,000 contribution margin – $84,000 fixed costs

= $14,000 operating income

$98,000 ÷ $14,000 = 7.0

New arrangement:
3,500 × $35 = $122,500 contribution margin

3 - 32
 Operating Leverage Example

$122,500 contribution margin

– $114,000 fixed costs = $8,500
$122,500 ÷ $8,500 = 14.4
The degree of operating leverage at a given level
of sales helps managers calculate the effect of
fluctuations in sales on operating income.

3 - 33
Learning Objective 9

Distinguish between
contribution margin
and gross margin.

3 - 34
Contribution Margin versus
Gross Margin

Contribution income statement emphasizes

contribution margin.

Financial accounting income statement

emphasizes gross margin.

3 - 35
THANK YOU!

3 - 36