Chapter 4:

COST-VOLUME-
PROFIT ANALYSIS:
A MANAGERIAL
PLANNING TOOL
CORNERSTONES OF MANAGERIAL ACCOUNTING, 6E
 BREAK-EVEN POINT IN UNITS
AND IN SALES DOLLARS
 Companies use CVP analysis to help them reach important
benchmarks, like breakeven point.
 The break-even point is the point where total revenue equals
total cost (i.e., the point of zero profit).
 Also the level of sales at which contribution margin just
covers fixed costs and when operating income is equal to zero.
 Since new companies typically experience losses (negative
operating income), they view their first break-even period as a
significant milestone.

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USING OPERATING INCOME
IN C-V-P ANALYSIS

 For CVP analysis, it is useful to organize costs into fixed and

variable components.
 Below is the income statement format that is based on the
separation of costs into fixed and variable components is called
the contribution margin income statement.

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in
part, except for use as permitted in a license distributed with a certain product or service or otherwise on a
password-protected website for classroom use.
LO-1
 USING OPERATING INCOME
IN COST-VOLUME-PROFIT
ANALYSIS (CONT.)

Direct Variable selling and

materials administrative costs
Direct labor

Variable
overhead

Fixed selling and

Fixed administrative costs
overhead
LO-1
 USING OPERATING INCOME
IN C-V-P ANALYSIS

 Contribution margin is the difference between sales

and variable expense.
 The amount of sales revenue left over after all the
variable expenses are covered that can be used to
contribute to fixed expense and operating income.

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 BREAK-EVEN POINT IN
UNITS
If the contribution margin income statement is recast as an equation, it
becomes more useful for solving CVP problems.

Basic CVP Equation

 Break-even units are equal to the fixed cost divided by the contribution margin per
unit.

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 BREAK-EVEN POINT IN
SALES DOLLARS
Managers using CVP analysis may use sales revenue as the measure of
sales activity instead of units sold. A units sold measure can be converted
to a sales revenue measure by multiplying the unit selling price by the
units sold:

For example, the break-even point for Whittier is 600

mowers; the selling cost is $400 per mower.
Breakeven in Sales $’s = 600 x $400 = $240,000 LO-1
 VARIABLE COST RATIO AND
CONTRIBUTION MARGIN RATIO

Any answer expressed in units sold can be easily

converted to one expressed in sales revenues.

Variable Cost Ratio Contribution Margin Ratio

Alternatively:

LO-1
 FIXED COST’S RELATIONSHIP
WITH VARIABLE COST
CONTRIBUTION & MARGIN
 RATIOS
Since the total contribution margin is the revenue remaining after
total variable costs are covered, it must be the revenue available
to cover fixed costs and contribute to profit.
 How does the relationship of fixed cost to contribution margin
affect operating income?
 There are three possibilities:
 Fixed cost equals contribution margin; operating income is zero; the
company breaks even.
 Fixed cost is less than contribution margin; operating income is greater than
zero; the company makes a profit.
 Fixed cost is greater than contribution margin; operating income is less than
zero; the company makes a loss.

LO-1
 UNITS TO BE SOLD TO
ACHIEVE A TARGET INCOME

 While the break-even point is useful information and an

important benchmark for relatively young companies,
most companies would like to earn operating income
greater than $0.
 CVP allows us to do this by adding the target income
amount to the fixed cost.
 First, let’s look in terms of units that must be sold.

LO-2
 SALES REVENUE TO
ACHIEVE A TARGET INCOME
 How much sales revenue must Whittier generate to earn an
operating income of $37,500?
 This question is similar to the one we asked earlier in
terms of units but phrases the question directly in terms of
sales revenue.
 To answer the question, add the targeted operating income
of $37,500 to the $45,000 of fixed cost and divide by the
contribution margin ratio. This equation is:

LO-2
 IMPACT OF CHANGE IN REVENUE
ON CHANGE IN PROFIT

 Assuming that fixed costs remain unchanged, the

contribution margin ratio can find the profit impact of a
change in sales revenue.
 To obtain the total change in profits from a change in
revenues, multiply the contribution margin ratio times the
change in sales:

Change Contribution Change

in = Margin x in
Profits Ratio Sales
LO-2
 GRAPHS OF COST-VOLUME-
PROFIT RELATIONSHIPS: THE
PROFIT-VOLUME GRAPH
 A profit-volume graph visually portrays
the relationship between profits (operating
income) and units sold.
 The profit-volume graph is the graph of the
operating income equation:
Operating income = (Price x Units) –
(Unit variable cost x Units) – Total
fixed cost
 In graph, operating income is the
dependent variable, and units is the
independent variable.

LO-3
 THE COST-VOLUME-PROFIT
GRAPH
 The cost-volume-profit graph depicts the relationships among cost,
volume, and profits (operating income).

LO-3
 CVP ANALYSIS
ASSUMPTIONS
Major assumptions of CVP analysis include:

1 2
Linear revenue and cost
Selling prices and costs
functions remain constant
are known with certainty.
over the relevant range.

3 4
Sales mix is known with
All units produced are
certainty for multiple-
sold; no finished goods
product break-even
inventories remain.
settings.
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 MULTIPLE-PRODUCT
ANALYSIS
 Cost-volume-profit analysis is simple in the single-product setting.
However, most firms produce and sell a number of products or
services.
 How do we adapt the formulas used in a single-product setting to a
multiple-product setting?
 One important distinction is to separate direct fixed expenses from
common fixed expenses.
 Direct fixed expenses are those fixed costs that can be traced to
each segment and would be avoided if the segment did not exist.
 Common fixed expenses are the fixed costs that are not traceable
to the segments and would remain even if one of the segments was
eliminated.

LO-4
 BREAK-EVEN CALCULATIONS
FOR MULTIPLE PRODUCTS

 When more than one product is produced and sold, managers

must estimate the sales mix and calculate a package contribution
margin.
 Sales mix is the relative combination of products being sold by a
firm.

Fixed Costs
Break-Even Packages =
Package Contribution Margin

© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in
part, except for use as permitted in a license distributed with a certain product or service or otherwise on a
password-protected website for classroom use.
LO-4
 COST-VOLUME-PROFIT ANALYSIS
AND RISK AND UNCERTAINTY

 Managers must be aware of so many factors in our

dynamic world. CVP analysis is a tool that managers use
to handle risk and uncertainty.

?
g e s in Risks?
n
Cha es??
pric
Fixed
?
ty ?? costs?
a in
ert
c Variable
Un
costs??

LO-5
METHODS TO DEAL WITH
UNCERTAINTY AND RISK
1. Management must realize the uncertain
nature of future prices, costs, and
quantities.

2. Management must assume a breakeven

“band” rather than a breakeven point.

3. Managers should use sensitivity or

“what- if” analyses.

LO-5
 MARGIN OF SAFETY

 The margin of safety is the units sold or the revenue earned above the break-
even volume.
 Example: If the break-even volume for a company is 200 units and the
company is currently selling 500 units, the margin of safety in units is:
Sales - Break-even units = 500 – 200 = 300 units
 If the break-even volume for a company is $200,000 and the current revenues
are $500,000, the margin of safety in sales revenue is:
Revenue - Break-even volume = $500,000 – 200,000 = $300,000
 The margin of safety as a percentage of total sales dollars can then be
expressed as:
Margin of safety ÷ Revenues = $300,000 ÷ $500,000 = 60%

LO-5
 OPERATING LEVERAGE

 Operating leverage is the use of fixed costs to extract

higher percentage changes in profits as sales activity
changes.
 Measure of the proportion of fixed costs in a company’s cost
structure.
 Used as an indicator of how sensitive profit is to changes in sales
volume.
 The degree of operating leverage (DOL) can be measured
for a given level of sales by taking the ratio of contribution
margin to operating income or:
Contribution margin ÷ Operating income

LO-5
 SUMMARY OF OPERATING
LEVERAGE

Operating Leverage
HIGH LOW
% profit increase with Large Small
sales increase
% loss increase with Large Small
sales decrease

LO-5
SENSITIVITY ANALYSIS

LO-5