COST-VOLUME-

PROFIT ANALYSIS
CHAPTER 7
Professor Garvin, JD; CPA – ACG2071
 Cost-Volume-Profit (CVP) Analysis
2

 Is a powerful tool that helps managers make important

business decisions
 Is a relationship among costs, volume, and profit or
loss
 Determines how much the company must sell each
month just to cover costs or to break even
 Helps managers decide how sales volume would need
to change to achieve the same profit level
 Components of CVP Analysis
3

 CVP analysis relies on the interdependency of five components or

pieces of information
 Sales price per unit

 Volume sold

 Variable costs per unit

 Fixed costs

 Operating income

 If you know or can estimate four of these five components, you

can compute the remaining unknown amount
 CVP Assumptions
4

 Change in volume is only factor that affects total costs; No

Volume discounts
 Managers can classify each cost as either variable or fixed
 These costs are linear throughout relevant range
 Revenues are linear throughout relevant range
 Inventory levels will not change
 The sales mix of products will not change
 CVP Example Facts: Kay’s
5 Posters
Kay has an Internet poster business. She currently sells
each poster for $35, while each poster has a variable cost
of $21. Kay has fixed costs of $7,000. Kay is currently
selling 550 posters per month.
 Contribution Margin Income Statement
6

Kay’s Internet poster bsn. example from prior slide

Sales revenue (550 posters)..................................... $ 19,250

Less: Variable expenses ............................................
(11,550)
Contribution margin ...................................................
7,700
Less: Fixed expenses...................................................
(7,000)
Operating income........................................................
 Contribution Margin per Unit
7

Sales price per unit $35

- Variable costs per unit (21)
= Contribution margin per unit $14
What will profit be if can sell 650 units next month (increase of 100)
Contribution margin (650 units x $14) $9,100
- Fixed Costs (7,000)
Operating Income $2,100
$1,400 increase in op.inc. when sell extra 100 posters
$14 CM/unit x 100 extra units = $1,400 increase in op.inc.
 Contribution Margin Ratio
8

Contribution margin ratio = percentage of each sales dollar that is

available for covering fixed expenses and generating a profit.
Contribution = Contribution margin/unit = $14 = 40% CMR
margin ratio Sales price per unit $35
We can also compute CMR from Contribution Margin Income St.

Contribution = Contribution margin = $ 7,700 = 40%

margin ratio Sales revenue $19,250
(Numbers above are from the Kay’s Internet poster example on previous slides.)
 Bay Cruiseline offers nightly dinner cruises off the coast of
9
Miami, San Francisco, and Seattle. Dinner cruise tickets sell for
$50 per passenger. Bay Cruiseline’s variable cost of providing
the dinner is $20 per passenger, and the fixed cost of operating
the vessels (depreciation, salaries, docking fees, and other
expenses) is $210,000 per month. The company’s relevant range
extends to 15,000 monthly passengers.
a. What is the contribution margin per passenger?
Sales revenue (1 passenger) $50
Less: Variable expenses (20)
Contribution margin/unit 30
 b. What is the contribution margin ratio?
10 Contribution Contribution margin/unit = $ 30 = 60%
margin ratio = Sales price per unit = $ 50
c. Use the contribution margin/unit to project operating
income if monthly sales total 10,000 passengers.
10,000 x $30 = $300,000 CM (210,000) TFC = $90,000 Op Inc.
d. Use the contribution margin ratio to project operating income
if monthly sales revenue totals $400,000.
Contribution margin ( $400,000 sales X 60%) $ 240,000
Fixed cost (210,000)
Operating Income $ 30,000
 Bay Cruiseline offers nightly dinner cruises off the coast of
11
Miami. Dinner cruise tickets sell for $50 per passenger. Bay
Cruiseline’s variable cost of providing the dinner is $20 per
passenger, and the fixed cost of operating the vessels
(depreciation, salaries, docking fees, and other expenses) is
$210,000 per month. The company’s relevant range extends to
15,000 monthly passengers.
If Bay Cruiseline sells an additional 500 tickets, by what amount
will its operating income increase (or operating loss decrease)?
Contribution Margin per unit x additional tickets
500 extra tickets X $30 CM/unit = $15,000 incremental profit
 Breakeven Point
12

 Breakeven point:
 Sales level at which operating income is zero
 If sales above breakeven point, then profit
 If sales below breakeven point, then loss
 At Breakeven point:
 Fixed expenses = total contribution margin
 Total sales = total expenses at B/E point
 Calculating Breakeven Point
13

 Three approaches to calculating breakeven:

 Income statement approach
 Shortcut approach using contribution margin/unit
 Shortcut approach using contribution margin ratio
 CM Income Statement Approach
14

Sales
- Variable Expenses
Contribution Margin
- Fixed Expenses
Operating Income

($35) x units sold) – ($21 x units sold) - $7,000 = 0

= 500 posters
 Cost-Volume-Profit Analysis
15

 The Profit Equation

 Profit = SP(x) – VC(x) – TFC

 Equation Abbreviations
 x = Quantity of units produced and sold

 SP = Selling price per unit

 VC = Variable cost per unit; TFC = Total fixed cost

 $0 = $35(x) - $21(x) - $7,000

 $0 = $14(x) - $7,000
 X = 500 units
 Short-Cut Approach to Calculating
16
Breakeven Using CM/Unit

Units sold = Fixed expenses + Operating income

Contribution margin per unit

Units sold = $7,000 + $0

$14
= 500 posters
 Short-Cut Using Contribution Margin Ratio
17

Sales in $ = Fixed expenses + Operating income

Contribution margin ratio
Sales in $ = $7,000 + $0
0.40
= $17,500
Dividing fixed costs by CM/unit gives breakeven in units
Dividing fixed costs by CM Ratio gives breakeven in sales
revenue dollars
 Finding the Volume Needed for a Target Profit
18
Using CM/Unit
CVP analysis helps managers determine what they need to sell to
earn a target amount of profit.
Units sold = Fixed expenses + Operating income
Contribution margin per unit
$7,000 + $4,900 $11,900
Units sold = =
$14 $14
= 850 posters
Check our calculations: Sales (850 units) x $35 = $29,750
Less: Variable Costs (850 x $21) ( 17,850)
Fixed Costs (7,000)
Profit $4,900
 Finding the Sales Volume Needed for a Target
19
Profit Using CM Ratio
CVP analysis helps managers determine what
amount of sales revenue needed to earn a target
amount of profit.
Sales $ = Fixed exp + Target profit (operating inc)
Contribution margin ratio
Sales $ = $7,000 + $4,900 = $11,900
0.40 0.40
Sales = $29,750 to generate profit of $4,900
Check: $29,750 ÷ $35 = 850 posters
 Use information from Bay Cruise Line Data to compute #
of dinner cruise tickets it must sell to break even.
20

a. Use the income statement equation approach.

($50 x units) – ($20 x units) - $210,000 = $0

$30 x units = $210,000
units = $210,000/$30
units = 7,000
b. Profit Equation: (Profit) = SP(x) – VC(x) – TFC
$0 = $50(x) - $20(x) - $210,000
x = 7,000 units

Facts: SP/unit = $50; VC/unit = $20; TFC = $210,000

 B. Use the shortcut contribution margin/unit approach, then
perform a numerical proof to ensure that your answer is correct.
21

Units sold = Fixed expenses + Operating income

Contribution margin per unit

Units sold = $210,000 + $0 = 7,000 tickets

$30
Proof: 7000 tix x $50sp/unit <VC/unit x 7000> <TFC>
$350,000 <$140,000> <210,000> = 0
C. Use your answers from a and b to determine the sales revenue
needed to break even.
7,000 units to break even X $50 sales price/unit = $350,000
Sales Revenue needed to break even
 D. Use the contribution margin ratio approach to
verify the sales revenue needed to break even.
22

Sales in $ = Fixed expenses + Operating income

Contribution margin ratio

Sales in $ = $210,000 + 0
0.60 (CM/unit ÷ SP/unit)

Sales in $ = $210,000
0.60
= $350,000 Sales Revenue to Break even
 Graphing the CVP
23 Relationships
Step 1:
 Choose a sales volume (Units x $Price)
 Plot point for total sales revenue
 Draw sales revenue line from origin through the plotted point
Preparing a CVP Chart
Co. sells units for $10 per unit.
Sales Dollars

$20,000

$15,000

$10,000 Revenues

$5,000

$0
0 500 1000 1500

Volume of Units
 Preparing a CVP Chart
25

Step 2: Draw the fixed cost line. Fixed Costs are $4,000
$20,000
$15,000
D o lla r s

Revenues
$10,000 Fixed Cost
$5,000
$0
0 500 1,000 1,500
Volume of Units
Preparing a CVP Chart
Step 3: Draw the total cost line (fixed plus variable)
Variable cost/unit is $4 $15,000

Dollars
$10,000 Revenues
Fixed costs
Total cost
$5,000

$0
0 500 1000 1500

Volume of Units
Preparing a CVP Chart
Step 4: Identify the breakeven point
$20,000 Breakeven point
Dollars
$15,000

$10,000

$5,000

$0
0 500 667 1000 1500

Volume of Units
Preparing a CVP Chart
Step 5: Mark
operating income
$20,000
and operating loss

Dollars
areas on the graph. $15,000 Breakeven point o me
g I nc
ra tin
$10,000 Ope

$5,000 s
L os
rating
Ope $0
0 500 667 1000 1500

Volume of Units
 Sensitivity Analysis
29

 Managers need to be prepared for increasing costs,

pricing pressure from competitors, and other changing
business conditions.
 Sensitivity Analysis:
 Conducts “What if” analysis
 What if the sales price changes?
 What if costs change?
 What if the sales mix changes?
 What if the Sales Price Changes?
30

 Calculate a new contribution margin/unit using the new sales

price
 Use the new contribution margin/unit to compute breakeven
sales in units
 Use the new contribution margin/unit to compute breakeven
sales to maintain target profit
 Using the new breakeven numbers, decide if a change should
be made to sales price
 Kay want to know what sales price/unit needs to be
31
to earn a profit of $10,000 next month?
Base Info: SP/unit - $35; VC/unit - $21; TFC - $7,000
Breakeven units – 500
Profit Equation: Profit=SP/unit(x) – VC/unit(x) - TFC

$10,000 = SP(500 units) - $21(500 units) - $7,000

SP(500 units) = $27,500 ÷ 500 units
SP = $55/unit
 What if she can sell 700 posters?
$10,000 = SP(700) - $21(700) - $7000; SP = $45.29
 What if Fixed Costs Change?
32

 Mgt. considering change in production process that will increase fixed

costs/month by $2,000, but will decrease variable costs/unit to $16.
Current Info Proposed
VC/unit = 21 $16
TFC = $7,000 $9,000
Currently selling 850 posters so
Current profit = $35(850) - $21(850) - $7,000 = $4,900
Proposed profit = $35(850) - $16(850) - $9,000 = $7,150
 What if Variable Costs Change?
Supplier raises price for Kay’s raw materials. Everything else stays same. What is breakeven point?
Higher variable cost/unit has same effect as lower sales price/unit – both reduce product’s cm/unit, so
increases B/E pt.
 What if Fixed Costs & Volume Changes?
33

 Sales Mgr thinks a $5,000 increase in advertising budget would increase sales by $12,250 to a total
of 1200 units. Should advertising budget be increased?
 Current: SP = $35/unit; Volume = 850 units
 Incremental CM: $12,250 x 40% CM Ratio = $4,900 Increased CM
 Less: incremental advertising expense (5,000)
 Decreased profit $ (100)
Proof: Current Proposed Difference
Sales $29,750 $42,000 $12,250
(VC) (17,850) (25,200) (7,350)
CM 11,900 16,800 4,900
TFC (7,000) (12,000) (5,000)
Incr. Profit(Loss) $ 4,900 4,800 (100)
 Information Technology and Sensitivity
34
Analysis
 Allows managers to perform a wide array of sensitivity
analyses before committing to decisions.
 Uses Excel spreadsheets to perform sensitivity
analyses
 Allows managers to estimate how one change (or
several simultaneous changes) affects business
operations
 Uses spreadsheet software to create CVP graphs
 Breakeven in Sales Revenue: Multiproduct
35
Firm
Kay has decided to start selling large posters in addition to
regular posters. None of her original costs will change.
Large poster sales price = $70;
V.C./unit = $40 so CM/unit = $30.
For every 5 regular posters sold, Kay expects to sell 3 large
posters. (5/8 of sales will be reg. posters & 3/8 will be large
posters, that is a 5:3 sales mix of posters).
Kay estimates total sales of 800 posters.
What is weighted-average CMR?
 Breakeven in Sales Revenue: Multiproduct
36
Firm
Total expected contribution margin:
Regular posters (500 x $14) $ 7,000
Large posters (300 x $30) $ 9,000
Total expected contribution margin $16,000
Divided by total expected sales revenue:
Regular posters (500 x $35) $17,500
Large posters (300 x $70) 21,000
Total expected sales ÷ $38,500
Wtd. Avg. Contribution margin ratio = 41.558%
 Breakeven in Sales Revenue: Kay’s Posters
37

B/E-Sales $ = Fixed expenses + Operating income

Wtd. Avg. Contribution margin ratio
B/E - Sales $ = $7,000 + 0 = $7,000
0.41558 0.41558
= $16,844 (rounded) Sales Revenue
For every 5 reg. posters, Kay expects to sell 3 lrg posters; 5:3 sales mix.
$16,844 ÷ 8 posters = $2,106 x 5 reg. posters= $10,530 rev from sale of reg.
posters, & $2,106 x 3 large posters = $ 6,318 rev from sale of lrg posters

Now Kay wants to know what sales revenue needs to be to reach target monthly
income of $10,000. (Just replace 0 above with $10,000)
Sales $ = $7,000 +10,000 ÷ .41558 = $40,907 Sales Revenue
 Bay Cruise Line decides to offer 2 types of dinner cruises: regular & executive
cruises. Exec. cruise includes free cocktails & a 5-course dinner on upper deck.
Fixed expenses stay at $210,000/mo & ticket prices & variable expenses are as
38
listed:
Regular Cruise Executive Cruise

Sales price per ticket $50 $130

Variable expense per passenger $20 $40

Assuming that Bay Cruise Line expects to sell four regular cruises for every executive cruise,
compute the weighted-average contribution margin per unit.
Sales Mix Calculation Regular Executive Total
Sales price per unit ........................ $ 50 $130
Less: Variable cost per unit ........... (20) (40)
Contribution margin per unit ........ $ 30 $ 90
Sales mix ....................................... x4 x 1 = 5
Contribution margin ..................... $120 $ 90 = $210
Weighted-average contribution
margin per unit ($210/5) ........... $ 42
 Same info as previous slide
39

Sales Mix Calculation Regular Executive Total

Sales price per unit $ 50 $130
Less: Variable cost per unit (20) (40)
Contribution margin per unit $ 30 $ 90
Sales mix x4 x 1 5
Contribution margin $120 $ 90 $210
Wtd-avg CM per unit ($210/5) $ 42
Is this weighted avg. C/M/unit higher or lower than the old C/M/unit when
they just sold regular cruises? (higher) Why?
Will this new sales mix cause Bay Cruiseline’s breakeven point to increase or decrease its
breakeven point?
 Sales Mix Calculation Regular Executive Total
Sales price per unit $ 50 $130
Less: Variable cost per unit (20) (40)
Contribution margin per unit $ 30 $ 90
40

Sales mix x4 x 1 5
Contribution margin $120 $ 90 $210
Wtd-avg CM per unit ($210/5) $42

Will this new sales mix cause Bay Cruise Line’s breakeven point to increase or
decrease from what it was when it sold only regular cruises?

B/E Sales in $ = Fixed expenses + Operating income

Weighted Average Contribution margin per unit

Sales in $ = $210,000 + 0 – B/E

$42 wtd avg CM/unit
= 5,000 tickets Decrease, down from 7,000 tickets before
 What if the Sales Mix Changes?
41
Must recalculate based on new Sales Mix
Sales Mix Calculation Reg Product Large Product Total
Sales price per unit $ 35 $ 70
Less: Variable cost per unit (21) (40)
Contribution margin per unit $ 14 $ 30
Sales mix x5 x 3 8
Contribution margin $ 70 $ 90 $160
Weighted-average contribution margin per unit ($160/8) $ 20
Sales Mix Calculation Regular Product Large Product Total
Sales price per unit $ 35 $ 70
Less: Variable cost per unit (21) (40)
Contribution margin per unit $ 14 $ 30
Sales mix x6 x 2 8
Contribution margin $ 84 $ 60 $144
Weighted-average contribution margin per unit ($144/8) $ 18
 Common Indicators of Risk
42

 Margin of Safety
 The excess of expected sales over breakeven sales
 Operating Leverage
 The relative amount of fixed and variable costs that make up
a company’s total costs
 Margin of Safety
43

 Excess of expected sales over breakeven sales

 Drop in sales that the company can absorb
before incurring a loss
 Used to evaluate the risk of current operations as
well as the risk of new plans

43
 Margin of Safety for Kay’s Poster Bsn
44

Margin of safety Expected sales Breakeven

= −
in units in units sales in units
= 950 units − 500 units
= 450 units
Margin of safety = Expected sales − Breakeven sales
in dollars
= $33,250 – $17,500

= $15,750
 Margin of Safety as a Percentage
45

Margin of safety in units

Margin of safety =
Expected sales in units
as a percentage 450 Units
=
950 Units
= 47.4% (rounded)

Margin of safety =
Margin of safety in dollars
Expected sales in dollars
as a percentage
= $15,750
$33,250
= 47.4% (rounded)
 High Operating Leverage
46

 High operating leverage companies have:

 Higher levels of fixed costs and lower levels of variable costs

 Higher contribution margin ratios

 For high operating leverage companies, changes in volume

significantly affect operating income, so they face:
 Higher risk

 Higher potential for reward

 Examples include golf courses, hotels, rental car agencies, theme

parks, airlines, cruise lines
 Low Operating Leverage
47

 Low operating leverage companies have:

 Higher levels of variable costs and lower levels of fixed costs

 Lower contribution margin ratios

 For low operating leverage companies, changes in volume do

NOT have as significant an effect on operating income, so they
face:
 Lower risk

 Lower potential for reward

 Examples include merchandising companies.

 Operating Leverage Factor
48

 How responsive a Co.’s operating income is to changes in volume

 Lowest value for Operating Leverage factor is 1, if Co. has no

fixed costs
Operating leverage factor = Contribution margin
Operating income
Operating leverage factor = $13,300 = 2.11 (rounded)
$6,300
If sales revenue increases by 10%, then operating income will
increase by 10% x 2.11 (OL factor) = 21% increase in op. income
 Using OLF to Measure Expected Change in Profit
Taco King & Mexi Land are competitors & reported same sales revenue &
before-tax profit during May:
49

If sales drop by 20% for both, which company suffers more?

Taco King Mexi Land

Sales $40,000 $40,000.

Variable costs (22,000) (8,000)
Contribution margin 18,000 32,000.
Fixed costs (8,000) (22,000)
Operating Income $10,000. $10,000.
Taco King Mexi Land
Degree of operating $18,000 CM $32,000 CM
= 1.8 OLF = 3.2 OLF
leverage $10,000 Op. Inc. $10,000 Op.Inc.

Decrease in profit 1.8 × 20% = 36% 3.2 × 20% = 64%

Decline in Profit Decline in Profit

Mexi Land’s higher operating leverage results in a larger profit decline.

END OF SEGMENT
Professor Garvin, JD; CPA – ACG2071