Topic 11

Cost–volume–profit analysis

Chapter 17

Adapted from slides ©2019 John Wiley & Sons Australia, Ltd
 Learning objectives

After studying this presentation, you should be able to:

17.3 explain the five basic assumptions of cost–
volume–profit (CVP) analysis
17.4 indicate the meaning of contribution margin
and identify break-even point and the use of break-
even analysis
17.5 determine target profit by applying formulas
17.7 describe the essential features of a CVP
statement of profit or loss.

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 Introduction: Cost–volume–profit analysis

• CVP analysis examines the effects of changes in costs

(fixed and variable) and volume (sales) on an entity’s
profits.
• CVP analysis is important for:
– planning
– setting prices
– determining the best product mix
– making the maximum use of production facilities.

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 17. 3 Cost–volume–profit analysis

• Five basic assumptions of CVP:

1. Costs and revenues are linear within the relevant
range.
2. All costs are identifiable as variable or fixed.
3. Costs are affected only by changes in activity level.
4. All units produced are sold.
5. Sales mix is constant if there is more than one
product. (we will not be doing multi- product
analysis)
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 17.4 Contribution margin

• Contribution margin (CM) – Expressed in Total Sales

= Revenue – variable costs
= Selling Price (SP)x Quantity sold (x) – Unit variable cost (VC) x x
– NB= variable cost includes variable production/ manufacturing cost and any
variable selling, administrative costs)
• Contribution Margin can be calculated per unit (Unit CM) = SP – VC
– How much of each sales dollar is left to contribute towards fixed costs and
profits?
• CM can be calculated as a ratio (CM ratio): Total CM ÷ Sales Revenue
Or Unit CM ÷ SP
– What percent of each sales dollar is left to contribute towards fixed costs and
profits?

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 Example 1

• E.g. 1 Calculate the i. unit CM and the ii. CM ratio

Solution:
$ %
CM ratio
Selling price $1.00 100 =$0.40/$1.00
Unit Variable cost 0.60 60
Contribution margin per battery i. 0.40 ii. 40%
The unit CM means that for every sales dollar earned, there is CM of 40 cents per unit sold to
cover the fixed costs.
CM ratio means that the CM is 40% of sales revenue (price) Therefore the variable cost ratio
is 100 - 40% = 60% of sales revenue (price)

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 17.4 Break-even analysis

• Determines the level of activity where

Total revenues (TR) equal total costs (TC).
• At the break-even point, there is zero profit or loss.
• Can be expressed in terms of sales dollars or sales units.
• Can be determined by:
– mathematical equation
– contribution margin technique
– cost–volume–profit graph (non examinable).

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 17.4 Break-even analysis

• Mathematical equation:
– Break-even sales can be defined as:
• required level of sales dollars.
• required units of sales volume.
– In the equation, variable costs can be expressed as a
proportion of sales revenue ( VC ratio) or as a dollar
amount.

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 17.4 Break-even analysis

To calculate BE sales units (x) use the following equation:

Sales Revenue = TVC + TFC + Profit
SP x Units = Unit VC x Units + TFC + 0

To calculate BE sales dollars or revenue use the following

equation:
Sales Revenue = TVC + TFC + Profit
Sales Revenue = VC ratio x Sales Revenue + TFC + 0
Where VC ratio = unit VC/ SP or VC/ Sales revenue

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 17.4 Break-even analysis

• Contribution margin technique:

– Break-even point can be defined in terms of sales units by the
formula:

– Break-even point can be defined in terms of sales dollars by the

formula:

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 Example 2 (i)

• E.g. 2 Calculate the BE point in i. units and ii. sales revenue

$ %
Selling price $1.00 100
Variable cost 0.60 60
Contribution margin per battery 0.40 40%
Fixed costs = $80,000

Solution:
Using the equation following the definition of BE
Rev = VC + TFC + P & let x (Units) be the number of BE units sold
SP x units = VC x Units + TFC +0
$1x = $0.6x + $80,000 + 0
X ($1- 0.60) = $80,000
x = $80,000 / $0.40 = 200,000 units or batteries (i)

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 Example 2 (ii)

• E.g. 12-2 Calculate the BE point in i. units and ii. sales revenue
$ %
Selling price $1.00 100
Variable cost 0.60 60
Or use the formula
Contribution margin per battery 0.40 40% TFC/ CM ratio =
Fixed costs = $80,000 $80,000/0.40=
$200,000

Solution:
Q= $80,000 / $0.40 = 200,000 units or batteries (i)
(ii) BE in revenue = BE (units) x S.P = 200,000 x $1 =$200,000.

The BE point means that when the business sells 200,000 units or sales amount to
$200,000, no profit or loss is earned or incurred.

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 17. 4 Margin of safety (MOS)

• The difference between expected or current sales and break-even sales.

• It can be expressed in units, dollars or as a ratio.
• The adequacy of margin of safety depends on the characteristics of the
business.
• For example, competitive position, general economic conditions.
• MOS (units)= Current/ expected sales units – BE sales units
• MOS ( $)= Current /expected sales revenue- BE sales revenue
• MOS %= MOS (units) OR = MOS ( $)
Current/ expected sales units Current/ Expected sales revenue

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 Example 3

 E.g. 3, assume the same information as in E.g. 2. The current sales level
is 300,000 units.
 Calculate the MOS in revenue.
 Current sales revenue = 300,000 units x $1 = $300,000
MOS = $300,000 - $200,000 (see slide 13 )
= $100,000 (in units = 300,000 -200,000 =100,000 units)
 The business has a very large MOS of $100,000 which means it is in a
low risk position
 Sales must drop by more than 33% (100,000/ 300,000) from the current
sales level before losses are incurred

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 17.5 Target profit

• Target profit is the profit objective for the product line.

• Break-even analysis is expanded by adding target net
profit to total costs.
• It can be determined using either a mathematical
equation, the contribution margin technique or graphic
presentation.

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 17.5 Target profit

• Mathematical equation:

• Contribution margin technique:

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 Example 4

• E.g. 4 Calculate the target sales i. units and ii. sales revenue to earn profit of $40,000.
$ %
Selling price $1.00 100
Variable cost 0.60 60
Contribution margin per battery 0.40 40%
Fixed costs = $80,000
Target profit= $40,000 Or use the formula TFC +
Solution: TOP/ unit CM=
Using the equation following the definition of BE $120,000/$0.40= 300,000
units
R = TVC + TFC + P & let x be the number of target units sold
SP(x) = unit VC x (x) + TFC + $40,000
$1(x) = $0.6QS + $80,000 + $40,000
x( $1- 0.60) = $120,000
x= $120,000 / $0.40 = 300,000 units or batteries (i) & (ii) = $300,000 Or use the formula TFC + TOP/
CM ratio $120,000/0.40=
$300,000

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 CVP for profit planning

• Management can use CVP to quickly predict effects of such

events ( operational changes) as:
– changes in sales revenues and costs
– matching competitor’s discount on sales price per unit
– investing in equipment (fixed costs) in order to reduce
labour (variable costs)
– changes in profitability with changes in variable or fixed
costs.

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 Example 5

• E.g. 5 Assume the same information as in E.g. 2. Fixed costs has

increased by $8,000; as a result of an increase in production capacity,
sales increased to 400,000 units. Calculate: i. the new BE point in
units, and ii. the profit at the new sales level.
Solution:
Contribution margin = $1- $0.60 =$ 0.40 no change
i. BE (units) = $80,000 +$8,000/ $0.40 = 220,000 units
ii. Profit = (400,000 x 0.40) - $88,000 Profit =CM -TFC
= $160,000 - $88,000
• = $72,000

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 Example 6

• E.g. 6 Assume the same information as in E.g. 2

• Due to competition, selling price decreased to $0.90 and sales units increase to
450,000.
• Calculate i. the new BE point in units and ii. New profit
Solution:
Selling price $0.90
Variable cost 0.60
New Contribution margin 0.30 per unit

i. New BE( units) = $80,000/$0.30= 266,667 (rounded up to nearest unit)

ii. New Profit = 450,000 x $0.30 - $80,000

= $135,000- $80,000
= $55,000

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 17.7 CVP statement of profit or loss

• CVP statement of profit or loss is used for internal

decision making only.
– Expenses are classified as variable or fixed.
• Financial reports for external use:
– classify expenses by function (e.g. cost of sales and
selling expenses)
– do not show contribution margin.

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17.7 CVP statement of profit or loss

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 Summary

• In this lecture we have covered:

• Assumptions of CVP analysis
• Calculation of unit CM and CM ratio
• Calculation of BE sales units and revenue
• Calculation of Margin of safety
• Calculation of target sales units/ revenue
• CVP or CM income statement
• NB : Also for CVP questions always assume each of the question requirement
is independent. For each requirement go back to the original information plus
use any additional information given for that requirement only

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