THE MODEL

COST-VOLUME-PROFIT:
APPLICATION IN THE
OPERATIONS
MANAGEMENT
 THE MODEL
COST-VOLUME-PROFIT

Read the sections on

your own:

• 1.2 Fixed Costs-

Variable Costs

• 2.1 CVP model

hypotheses and
limitations
 COSTS: CLASSIFICATION

The total cost of producing a good or providing a service can

be considered as the sum of fixed costs (FC) and variable
costs (VC).

FC + VC

 Fixed Cost (CF) unaltered by increasing or decreasing the

volume of activity (renting an industrial warehouse)

 Variable Cost (CV) depends on the volume of activity

(raw materials)
Graphically
 THE VOLUME OF ACTIVITY

  Volume of activity (Q): "production made by the

company during the time or period of reference, in
effective or predicted market condition".

 Average Variable Cost (AVC): The result of dividing

variable costs by the level of production.

 AVC might vary with the volume of activity

 We simplify the model by assuming that the AVC is
constant for all Q
 THE CVP MODEL

 The CVP model is a tool that relates costs, profit and volume
of activity, with the aim of obtaining information suitable for
making decisions.
 Taking into account the assumptions and being aware of its
limitations, the CVP model can be very useful in
planning and making decisions in different areas of
business management.
 The assumptions and limitations of the model are
important to know when it can be applied (Section 2.1 of
the ebook)
 2.1. HYPOTHESIS AND LIMITATIONS OF THE
CVP MODEL

• Hypothesis 1. Classification and typology of costs

The analysis is carried out in the short term, whereby any cost may be classified
as a fixed cost or variable cost. The volume of production is the only relevant
factor that affects the costs, thus, the fixed costs remain fixed independently of
the variation in volume of production, and the variable costs vary in proportion
to the volume of production.
• Hypothesis 2. The revenue function
The sale price remains constant for any level of activity. The revenue function
can also be represented as a straight line. The quantity produced is fully sold for
any volume of activity, that is, there is no variation in stock of finished
products.
• Hypothesis 3. Stability of external factors
Any external factor may affect any of the variables included in the model (costs,
volume and/or profit); it is assumed to remain invariable for any volume of
production during the period of analysis (e.g. price of the factors of production,
technology, company policies, production efficiency, others).
 2.1. HYPOTHESIS AND LIMITATIONS OF THE
CVP MODEL

• Hypothesis 4. Multiproduct companies

The CVP model can be applied to any company, independently of the
number of products it sells.
• In the case of multiproduct companies, the percentage represented by
the quantity produced/sold for each product out of the total production
is considered stable for the relevant interval of production.  

• Hypothesis 5. Determinist model

All the values are known with certainty. Hence, the model does not take
into account adjustments due to risk or uncertainty for any of its
variables. In real business, variables such as sale price, variable cost or
demand may be unknown, but the model considers all these factors to be
certain.
 2.1. HYPOTHESIS AND LIMITATIONS OF THE
CVP MODEL

Limitation 1. Overall analysis of the results

The CVP analysis must be global and conclusions must not be
drawn from isolated data and partial results.

Limitation 2. Qualitative factors are not taken into account.

The quality of the finished products, customer satisfaction,
employee motivation are, amongst others, factors that are outside
the scope of the model’s analysis, although they are, undoubtedly,
determinant in business management.
 2.2 CVP MODEL DETERMINATION

 The CVP model is based on the connections

between cost, volume, and profit variables.

 From the basic concept that profits (P) are the

difference between revenue (R) and total costs
(TC), we will come to establish the relationship
between production volume, costs and profit.

P=R-TC (1)
 2.2 MODEL DETERMINATION

 Revenues (R) depend on the quantity of product sold

(Q) and the sales price (SP) of the product;
R=Q x SP (2)

 Total costs (TC) are divided into fixed (FC) and

variables (VC);
TC =FC +VC (3)
 We assume that variable costs are linear in volume,
each unit increasing the cost in AVC units. So, we can
express the variable cost as
VC=AVC x Q (4)
 2.2 CVP MODEL DETERMINATION

We want to find the quantity to be produced as a function

of Profits, Fixed Costs, Average Variable Cost, and Price, i.e.
finding the function
Q(P,SP,FC,AVC)
If you replace equations 2, 3 and 4 in 1 and clear the
production volume(Q) you will find the function.

I'll give you 4 minutes to do it. Cheer up!!

This function will tell you how much you need to sell to obtain
profits P, given that selling price is SP, fix costs are FC, and
to produce one extra unit increases costs in AVC
 2.2 CVP MODEL DETERMINATION

 Replacing equality (4) in the (3) we have left,

TC =FC + AVC × Q (5)

finally replacing (5) and (2) in equality (1) we have to,

P=SP x Q – (FC + AVC x Q)

Moving FC to the left and taking common factor Q we get

P +FC=Q x (SP - AVC)

finally, isolating the volume of production we have,
 2.2 CVP MODEL DETERMINATION

 Equality (6) is the basic equation of the model

which allows us to determine what volume of
production is necessary to make a profit P, with
certain costs and a given sales price.

Tip: Do not learn the formula by heart, learn to derive it

and understand its meaning
 INTUITION OF THE FORMULA

 FC: The cost we have for running the business

 P: Our profit-objective
 P+FC: How much (net) money we need to generate in order to fulfill our
monetary objective
• 
 SP: Gross money generated by one unit produced
 AVC: Cost for producing one extra unit
 SP-AVC: Net money generated by each extra unit we produce/sell
 This is called the CONTRIBUTION MARGIN (CM): How much each unit contributes to our
objective
 INTUITION OF THE FORMULA

 So, if we divide “how much money we need to generate in order to fulfill our
monetary objective” by the “net money generated by each extra unit we
•   produce/sell”, we get how many units we need to produce/sell in order to fulfill
our objectives.
 As simple as that!!!!! If you want 100$ and each unit sold gives you 20$, you
need to sell 100/20=5 units.
 CVP MODEL, CALCULATED IN
REVENUE VOLUME

 Similarly, we can find the revenue volume (R) as a function

of Profit, Sale Price, Fixed Costs, and Average Variable Costs

R(P,SP,FC,AVC)

In fact it's immediate, since revenue is R=Q x SP, then, since

for getting the desired profit given SP, FC, and AVC, we had
to produce/sell Q(P,SP,FC,AVC) units at SP$ per unit, we need
to generate a revenue equal to
 CVP MODEL, CALCULATED IN
CAPACITY UTILIZATION RATE
  interesting question that the CVP model can answer is whether the
An
objective is feasible and, if so, what share of our capacity we need to
use.
For this, we should first define some concepts:
 The designed capacity (Qd ) is the maximum number of units that
a factory can produce in a given time period.
 The capacity used (Q) is the number of units that actually
produced in a given time period. It will be the volume of production.
 The capacity utilization rate (CUR) is defined as the percentage of
the designed capacity of the production unit that has been used over
a given period of time.
 CVP MODEL, CALCULATED IN
CAPACITY UTILIZATION RATE
 We can find the Capacity Utilization Rate (CUR) as a function
of Profits, Sale Price, Fixed Costs, and Average Variable Costs
and designed capacity
CUR(P,SP,FC,AVC, Qd)

Again it is immediate as the CUR is, then

The equation expresses the percentage of utilization of our production

capacity necessary to achieve a certain profit, considering known costs and
sales price. Thus, an objective is feasible if, and only if, CUR≤1.
 DETERMINATION OF THE BREAK-EVEN
OR PROFITABILITY THRESHOLD

 Amount of the break-even (Qbe): Number of units that the company

must produce and sell to cover all its costs and not make any profits or
losses. That is, the amount that makes zero profits 0.

 In the same fashion, it is possible to calculate the break-even revenue

(Rbe)

 and the Break-even capacity utilization rate (CURbe)

CVP MODEL GRAPHIC ANALYSIS
 EXERCISE (2.1.a)

The managers of a discotheque plan to organise a New Year’s Eve

party with an open bar. From the party held the previous year
they have the following data (see Table 2):
Fixed cost Rental of premises 5,000
Fixed cost
Staff costs (fixed) 2,500
Fixed cost
Variable cost Advertising 9,500
Beverage consumption 50,000
Other fixed costs 5,000
Other variable costs 20,000
A total of 2,000 people attended. By using this information:

a) Calculate the number of customers that were necessary to

reach the break-even point if the sale price of the tickets was 50
euros.
SOLUTION (2.1.a)
 EXERCISE (2.1.b)

 b) This year, the management of the discotheque is planning

the possibility of doing additional advertising worth 10,000€,
hoping to ensure the sale of 2,300 tickets, the maximum
capacity of the venue (the data concerning FC and AVC of the
previous year are maintained). They would like to know:

 b1) What price should the tickets be sold at in order to

obtain a profit of 50,000€?

 b2) What will the new break-even point be at this price?

SOLUTION (2.1.b)
 4. APPLICATION OF THE CVP MODEL TO
COMPANIES OF THE HOSPITALITY SECTOR

 Companies in the hospitality sector derive their income from

the provision of multiple services. Thus, a hotel earns income
from renting its rooms, bar and restaurant departments and
other complementary activities such as telephone, laundry,
meeting room rental, sports activities, etc.
 The number of rooms available in a hotel is a fixed factor
and room rental income will be determined by the room
occupancy rate and the price set for each room.
 On the other hand, income in other areas such as bars and
restaurants depends not only on the number of rooms occupied
but on the number of people per day (stays), occupying those
rooms.
 4. APPLICATION OF THE CVP MODEL TO
COMPANIES OF THE HOSPITALITY SECTOR

Example:
 A hotel with 200 double rooms occupied by 200 guests, has
100% room occupancy and an income-generating capacity in
other areas of 200 stays.
 The same hotel with 200 double room could have 150 rooms
occupied by 300 guests. Thus, the hotel now has a lower
room occupancy (75%) but a higher capacity to generate
income in other areas as now it has 300 stays.
 That is why, in the calculation of revenues (and therefore
also in the calculation of the costs associated with those
revenues) the volume of production can be expressed in
different ways
 UNITS OF MEASUREMENT MATTERS!!!!!
 4. APPLICATION OF THE CVP MODEL TO
COMPANIES OF THE HOSPITALITY SECTOR

 In this section, we’ll ignore other areas of the hotel and focus
exclusively on room income

We’ll retake this issue in session 3 (multiproduct)

Number of Rooms Occupied (RO), equals the number of

units produced. Variable room revenues and costs will be
expressed in relation to this parameter.

Room Occupancy Rate: (ROR)- It is calculated as the ratio

between rooms occupied and rooms available.
 4. APPLICATION OF THE CVP MODEL TO
COMPANIES OF THE HOSPITALITY SECTOR

 Number of stays (S), equals the number of people staying

at the hotel one given day.

Room Stay Rate (RSR) per room, determines the average

number of people occupying each room. In this way we
can analyze, from a given room occupancy, the average
income per stay obtained in other areas of activity.
 EXERCISE (4.1)

A hotel with 200 double rooms open all year round obtains
revenue of 25 € per stay. The hotel’s fixed costs amount to
450,000€, and its variable costs per stay are 13 €. The room
stay rate is 1.5. With these data,

a) Calculate the room occupancy rate the hotel needs to

reach the break-even point

b) How many stays will the hotel need to make a profit of

400,000 euros and what percentage of room occupancy
does it represent?
SOLUTION (4.1.a)
SOLUTION (4.1.b)
 For the next class....

 Check out the CVP model

 Start practicing with exercises! Start now don't

leave it for the end!