Unit 3

Cost-Volume-Profit Analysis

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 Cost-Volume-Profit Analysis
 What is Cost-Volume Profit Analysis?

It is the study of the relationship between output

volume or revenue (sales), expenses (costs), and
net income (net profit).

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 CVP Analysis Cont’d
The knowledge of CVP relationship is
critical to answer many management
questions related to operations such as:
What will happen to financial results
for a given change in operating
activities?
 E.g. What will happen to net profit if
sales increases by 25%?

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 Break-even

What is break-even ?

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 Break-even

 Break-even is:
 a situation where total revenue of a
firm equals its total costs or net
profit is zero.

 Revenue=Costs <=> Net Profit=0

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 Break-even Point

What is break-even point?

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 Break-even Point

The break-even point is:

The level of sales (either in birr or
unit sales)at which total revenue
equals total costs or profit is zero.

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 Break-even Point

Why break-even point is so important

in the study of cost-volume-profit
relationships?

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 Break-even Point

The break-even point is so important

in the study of cost-volume-profit
relationships because
“finding the break-even point is
often the first step in planning
for profit.”

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 Break-even Point

One direct use of the break-even

point is to assess possible risk
(business risk) of operating at a given
level as measured by the size of
Margin of Safety.

What is margin of safety?

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 Margin of Safety
The margin of safety shows how far sales
can fall below the planned level before
losses occur.
Margin of safety can be stated in units,
birr sales or in percentage.
 Margin of Safety in:
Units -> Planned Unit Sales – BE Unit Sales
Birr -> Planned sales in Br – BE sales in Br
%-age-> Excess of planned over BE sales/Planned sales
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 Margin of Safety

Activity 1
If a company with BE sales of 300,000
units plans to sale 500,000 units, what
is the margin of safety in units and
percentage? Interpret it.

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 Margin of Safety
Solution for Activity 1
Its margin of safety is 200,000 units (which
is 500,000 less 300,000),
or
It can be said that actual sales of the
company can drop by 40%
(=200,000/500,000) before the company
incurs a loss, other things being equal.

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 Demonstration on CVP Analysis

Demonstrative Data
Consider the following data of an
assembly plant of pocket calculators
operating in Addis:

Selling Price Birr 50

Variable cost/unit 30
Contribution margin/unit Birr 20
Annual Fixed Costs Birr 200,000
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 Techniques of Computing BEP

1. Contribution –Margin Technique

It works in terms of the profit
contribution of each unit sold or every
birr sales towards covering the total
fixed costs of the firm.
 It is a common sense approach.

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 Contribution –Margin Technique
The break-even point is reached when
enough units are sold to generate a total
contribution margin (CM)that equals to the
total fixed costs (FC).
This implies that:
Total CM = Total FC
Or
Total Revenue = Total Costs

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 Contribution –Margin Technique
A formula for this purpose can be the following:
Break-even point in units= Total fixed costs
(BEP in units) CM per unit

For our example,

 BEP in units =Br200,000/Br20 =10,000 P.Cs.
 Note that computing BEP in birr sales is some
times important when no single price or variable
cost applies to all products sold by a company

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 Contribution –Margin Technique
 For the pocket assembling firm, the relationship
between sales and variable costs looks like this:
Per unit Percent
Selling Price Br 50 100%
Variable Costs/ Unit 30 60
Contribution Margin/ Unit Br 20 Br 40 %

How would you interpret the contribution

margin percentage of 40%?

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 Contribution –Margin Technique

The contribution margin percentage of

40% tells us that 40% of each birr sales
is available for the recovery of the
firm’s fixed expenses and the making
of net profit.

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 Contribution –Margin Technique

BEP in birr sales= Total fixed costs

(BEP in Br sales) CM ratio
Then,
BEP in Br sales = Br 200,000 /0.4 = Br 500,000

If one is dealing with a single product, the

BEP in birr sales can also be calculated
as follows:
10,000 units times Birr 50= Br 500,000

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 Contribution –Margin Technique

 Note that stating volume in birr

sales is useful for companies selling
many different types of products or
services having the same profit
margin.

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 Techniques of Computing BEP

2. The Equation Technique

It is a mathematical model that can be
applied to any contribution approach
income statement. That is:

Sales – variable exp. – fixed exp. = net income/or net loss

At BE net income is zero, then
Sales – variable expenses – fixed expenses = 0

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 The Equation Technique
• Let X= the number of units to be produced
and sold to break-even. Then,

Br 50X – 30X – 200,000 = 0

20X= 200,000
‫ ؞‬X=200,000/20 = 10,000 calculators
 How would you calculate the BEP in birr
sales? Recall the variable cost ratio or percentage
is 0.6 or 60%.

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 The Equation Technique

• Let S= sales in birr needed to break-even.

Then,
S – 0.6S – Br 200,000 = 0
0.4S = 200,000 S=
200,000/0.4=Br 500,000

 Note that contribution margin technique is

a short-cut version of the equation
technique.
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 The graphic technique
3. The graphic technique.
The graphic technique shows the BEP
as an intersection between the sales
line and the expenses (costs) line.
 The graph also shows the potential
profit or loss at any level of activity.

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 The graphic technique
Break-even Chart

1,600,000 Profit
region
1,400,000
Br
1,200,000 BEP 10,000
units or
1,000,000 500,000 Br. Fixed Cost

Total Costs
800,000
Loss
Total
600,000
region Revenue

400,000

200,000

0
0 1000 Number of10000
5000 Units Sold 20000 30000

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 Changes in BEP

What are the key variables that

affect the break-even-point?

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 Changes in BEP
The key variables that change the break-
even-point are:
1. Fixed costs and
2. Contribution margin per unit
o Changes in selling price
o Changes in variable costs per unit or both.

 Sensitivity analysis has to be made to

assess the effects of changes in these
variables on BEP.
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 Change in BEP
 Impacts of Changes in Fixed Costs.
Fixed costs and break-even-point
are positively related.

 Keeping other things equal, a given

percent increase in fixed costs would
cause the same percent increase in
break-even-point.

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 Change in BEP

Activity 2
If the fixed costs of our example firm
increases by 10%, what will happen to the
break-even point both in units and birr
sales?

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 Change in BEP

Solution for Activity 2

A 10% increase in fixed costs will be
followed by the same 10% increase in
BEP.

That is,
New T. Fixed Costs= Br 200,000 * 1.1 = Br220,000
– New BEP in units = 220,000/20 = 11,000 units
– New BEP in birr = 220,000/0.4 = Br 550,000
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 Change in BEP
• Note that BEP increase by 10%, i.e. units
increases from 10,000 to 11,000 and birr
sales increases too, from Br 500,000 to Br
550,000.

• The key lesson of the above analysis:

Companies can decrease break-even-
point by reducing fixed costs such as
property taxes, insurance, depreciation,
advertising, and supervisor’s salaries.
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 Change in BEP

 Impacts of changes in CM Per Unit.

Contribution margin per unit and break-
even-point are inversely related.

 When CM per unit decreases for any

reason, a company needs to sale more
to break-even, other wise it will suffer
from losses.

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 Change in BEP
i) Change in variable costs per unit.
 How variable costs are linked to
BEP?
Activity 3
 If variable costs per unit
decreased by Br 5.00 per unit,
everything else remains the same,
what will happen to BEP?
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 Change in BEP
Solution for Activity 3
New variable cost per unit = Br 30- 5= Br 25
New CM/ unit = Br 50-25= Br 25
New BEP in unit = 200,000/25 = 8,000
New BEP in birr = 200,000/0.5 = Br 400,000

 Lesson learned from this analysis:

A decrease in variable costs increases
contribution margin per unit and that causes the
break-even point to decline and vice versa.
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 Change in BEP

ii) Change in selling price (SP).

 How SP and BEP are related?

Activity 4
If the selling price decreased by Br
4.00, keeping other things constant,
what will happen to BEP?
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 Change in BEP

Solution for Activity 4

New CM/ unit = (50-4) -30 = Br 16
New BEP in units = Br 200,000/16 = 12,500
New CM ratio = CM per unit/selling price
= 16/46 =0.3478
New BEP in birr = 200,000/0.3478 = 575,043

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 Change in BEP

OR
BEP in units Times Selling Price= 12,500 * 46= 575,000
• (The difference birr 43 is the result of rounding error).

• Lesson learned from the above analysis:

A decrease in selling price decreases CM
per unit and hence increases the BEP both
in units and birr sales.

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 Target Sales for Planned Profit

Planning for Profit.

Remember: The knowledge of the
BEP is an important starting place
in the effort of planning for profit.
Role of CVP analysis : It can be used to
determine the sales level needed to achieve
the desired level of profit by a firm.

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 Target Sales for Planned Profit

Activity 5
If our example firm plans to earn birr
500,000 profits during the coming
year, what is the target sales volume in
units and in Birr sales to earn the
desired profit?

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 Target Sales for Planned Profit
Solutions for Activity 5
Two approaches:
(1) The Total Approach.
• It seeks for the total target sales volume.
Target sales = (Total FC +Target NP)/ CM per unit
in units
= (Br 200,000 + 500,000)/20 =35,000 units
Target sales in Br =(T. FC + Target NP)/ CM ratio
= (Br 200,000+ 500,000)/0.4
= Br 1,750,000
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 Target Sales for Planned Profit
(2) The Incremental Approach
– Emphases on the incremental or additional sales
needed over and above the break-even level sales
to earn the desired net profit.
Target sales in units = BEP in units +
Target Net Profit/ CM per unit
= 10,000 units + Br 500,000/20 =35,000 units
Target sales in birr = BEP in birr +
Target Net Profit/ CM ratio
= Br 500,000 + Br 500,000/ 0.4 = Br 1,750,000
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 Profit Planning with Tax
 The Impact of Tax on Profit Planning
How tax influences the target sales
volume?
• Will it increase or decrease the target (or
desired) sales volume?

What is the impact of tax on break-

even level?
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 Profit Planning with Tax

 When there is income taxes, each Birr sales

over and above the break-even sales needs to
recover
1) the incremental cost per Birr sales ,
2) come up with an amount that can cover
income taxes that have to be paid to the
government and
3) the amount of after tax net profit desired.

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 Profit Planning with Tax

 In short, the introduction of tax will increase

the target sales volume to earn a desired net
profit.
 According to the equation technique,
Sales –TVE– TFE= (After Tax NP)
(1- T)

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 Profit Planning with Tax

Activity 6
o If our pocket calculator producing
company is subjected to a 20% tax rate
and planned to earn Birr 500,000 after tax
profit during the current year, what level of
sales in birr and units would enable the
firm to earn the targeted net after tax
profit?

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 Profit Planning with Tax
Solutions for Activity 6
Target sales in Birr
Recall that the variable cost percentage is 60%:
(variable cost /sales) OR
(1- CM percent)
Let S = Target sales in birr
S – 0.6S – 200,000 = 500,000/ (1- 0.2)
0.4S = 625,000 +200,000
S= 825,000/0.4 = Br 2,062,500
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 Profit Planning with Tax

 Target sales in units

Target Sales units = T. Sales Birr/ Selling Price
= Br 2,062,500/50 = 41,250 units
OR
Let N=the target sales in units to earn the
desired after tax net profit.

50N – 30N -200,000= 500,000/ (1- 0.2)

N= 41,250 units

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 Sales Mix Analysis

What is Sales Mix?

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 Sales Mix Analysis

Sales mix is understood as the relative

proportions or combinations of quantities of
products or services that comprise total sales.

Why sales mix is so important in

planning?

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 Sales Mix Analysis
Sales mix is so important in
planning for two reasons:
i. A change in product mix will change the
cost-volume-profit relationships.
ii. When actual sales mix of a firm is
different from the planned sales mix,
actual profit will be different from the
targeted profit, other things being equal.

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 Sales Mix Analysis

Activity 7
 Consider the following sales mix and
other planned data for the current year
of a company, a company that produces
two different models of pocket calculators.

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 Sales Mix Analysis
Model
W R Total
Sales in units 500,000 100,000 600,000
Sales @Br 20 and 30 Br 10,000,000 3,000,000 13,000,000
Var. exp.@ Br16 and 21 8,000,000 2,100,000 10,100,000
Cont. M. @ Br4 and 9 Br 2,000,000 900,000 2,900,000
Fixed Expenses 1,450,000
Net Income Br1,450,000

Given the above information, what quantity of model

W and R will be needed for the firm to break-even?

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 Sales Mix Analysis
Solution for Activity 7
The sales mix from the above relationship can be
formulated as follows: 5R= W or R= W/5
Where,
W= the number of model W pocket calculators produced
R= the number of model R pocket calculators produced

 The current sales mix is that for every unit of

model R pocket calculator five units of model W
are produced.

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 Sales Mix Analysis

Recall that at BE,

Sales –Var. Exp. – F. Exp.= Zero Net Income

[20(5R) +30(R)] -[16(5R) + 21(R) ] – 1450,000 = 0

130R- 101R = 1,450,000
R= 50,000
Therefore,
W= 5(R) = 50,000 *5 = 250,000
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 Sales Mix Analysis
Summary on the importance of sales mix:
1. When the actual sales mix varies from what is
planned, the break-even point will change.

2. Managers are not interested in the break-even

point for its own sake. Instead, they want to
know how changes in a planned sales mix will
affect net income.

3. When the sales mix changes, the break-even

point and the expected net income at various
sales levels will also change.
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 Sales Mix Analysis
Activity 8
• If the actual sales mix for the
current year is 520,000 units of
model W and 80,000 units of model
R, other things being equal, what
will happen to the actual net income
for the year? Explain the difference
between actual and targeted profit?

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 Sales Mix Analysis

Solution for Activity 8

That is,
NI= [(520,000 * Br 4) + (80,000 * Br 9)]
– 1,450,000 = Br1,350,000.

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 Sales Mix Analysis
What has happened?
Though the firm produced and sold the same
total number units, 600,000 (=520,000+80,000)
as was planned, because of the change in the
sales mix the actual net income has become Br
1,350,000 instead of Br 1,450,00: Br100,000
short of targeted profit.

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 Sales Mix Analysis

A net decline in profit of Br100,000 resulted as the

firm sales less of more profitable product ( R) and
more of less profitable product (W).That is :
Increase in profit:
More of W 20,000* 4= 80,000
Decrease in profit:
Less of R 20,000 *9=180,000
Net Decline in Profit Br 100,000

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It is Over!

Thanks.

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