Chapter 7

Cost Volume Profit Analysis

Contents
1. Meaning

2. Purpose

3. Assumptions

4. techniques
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 CVP Analysis- Overview
2

 Cost-Volume-Profit (CVP) analysis is a technique that

examines the change of profits in response to changes
in sales volume, costs and prices. Similarly, it can be
defined as the study of the effects of changes in cost
and volume on a company’s profits.
 Cost-Volume-Profit (CVP) analysis examines the
behavior of total revenues, total costs and operating
income as changes occur in the output level, selling
price per unit, the variable cost per unit and/or the
fixed costs of the product.
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 CVP analysis is important to profit planning.

 CVP analysis is critical in management decisions such as:
1. The volume of sales needed to achieve a targeted level
of profit
2. The amount of revenue required to avoid losses
3. determining product mix: Which products or services
to emphasis
4. Whether to increase fixed costs
5. What profit can be expected on a given sales volume
6. maximizing use of production facilities,
7. setting selling prices

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 Because CVP is so important, management often wants

the information reported in a special format income
statement.
 The CVP income statement is for internal use only,
classifies costs and expenses as fixed or variable, reports
a contribution margin in the body of the statement.
 Contribution margin – amount of revenue remaining
after deducting all variable costs
 The contribution margin is often reported as a total
amount and on a per unit basis.
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 Assumptions of Cost-Volume-Profit Analysis
5

CVP analysis is based on the following general assumptions:

1. Changes in level of activity are the only factors that affect costs and revenue.
2. Total costs can be separated in to variable and fixed components.
3. When represented graphically, the behavior of total revenues and total costs
are linear (straight line) in relation to output level.
4. Selling price per unit, variable cost per unit and fixed costs are known and
constant.
5. When more than one type of product is sold, the sales mix will remain
constant.
6. All revenues and costs can be added and compared without taking into account
the time value of money.
7. All units produced are sold.

 When the above assumptions are not valid, the results of CVP analysis may
be inaccurate.
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 TECHNIQUES OF CVP ANALYSIS
6

CVP analysis could be studied using

1. Equation,
2. contribution approach and
3. Graphical Methods.

1. EQUATION METHOD
CVP analysis begins with the basic profit equation.

Net Income = Total Revenue – Total Costs

Separating costs in to variable and fixed categories, we express

profit as:
Net Income = Total Revenue – Total Variable costs – Total Fixed costs

Contribution Margin refers to the excess of selling price over

the variable cost. 11/09/2022
7

 Similarly, it represents the amount of revenues

minus variable costs that contributes to recovering
fixed costs.
 Once fixed cost is fully recovered, the remaining
contribution margin increases operating income.

Total Contribution Margin = Total Revenues(sales) – Total Variable

Costs

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 2. Contribution Margin Approach Ratio
8

Contribution Margin Ratio

 Some managers prefer to use a contribution margin ratio in CVP
analysis. The contribution margin ratio is the contribution margin per
unit divided by the unit-selling price.

 Contribution Margin Ratio = Contribution Margin per unit

Selling Price Per Unit

 Example: Assume, the contribution margin per unit is Br 60 and the

selling price per unit is Br 120, the contribution margin ratio will be
50% (Br 60 ÷ Br 120).
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 The contribution margin ratio of 50% implies that Br 0.5

of each sales dollar is available to apply to fixed costs
and to contribute to net income.
 This expression of contribution margin is very helpful in
determining the effect of changes in sales on net income.
 For example, net income will increase Br 2,000 (50% 
Br 4,000) if sales increase Br 4,000.
 Thus, by using the contribution margin ratio, managers
can quickly determine increases in net income from any
change in sales.
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 Break-Even Point Analysis

10

 The Break-Even Point is that quantity of output

sold at which total revenues equal total costs- that
is, the quantity of output sold at which the net
income is zero.
 The process of finding out the point is BEP
Analysis.
 The Break Even Point can be computed through:
1. Mathematical Equation Method
2. Contribution Margin Method
3. Graphical Method 11/09/2022
 1. Equation Method

11

 To use the equation method to determine break

even, the income statement is expressed as the
following equation.
 Net Income = Sales – total Variable cost – total Fixed costs
 Net income = SPU(Q) – VCU(Q) - FC

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 At the Break Even Point, the net income equals to

zero or all sales equals with all costs.
 This equation provides the most general and easiest
to remember approach to any CVP situation.
 Refer the previous illustration. The Break Even
Point in terms of units sold and dollar sales is:
 Net Income = (Quantity × selling price per unit) –
(Quantity × Variable cost per unit) – Fixed cost

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 Example
13

 At Break Even Point Net Income is zero.

(Quantity  Br 120) – (Quantity  Br 60) – Br 10,500=0
Quantity (Br 120 – Br 60) =Br 10,500
Quantity at BEP = Br 10,500  (Br 120 – Br 60)
Quantity at BEP = Br 10,500  Br 60 = 175 Units
Dollar Sales at BEP = Unit selling price  Quantity
Dollar sales at BEP = Br 120  175 units = Br 21,000
 At 175 units Sold and revenue of Br 21,000, the net

income becomes zero.

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 Therefore, if the sell is less than 175 units, there will be a

loss, if it is 175 units, net income will become zero and if
the sell is greater than 175 units, there will be a profit.
2. Contribution Margin Method
 The contribution method simply rearranges the terms in

Equation method.
Net Income = TR – TVC – TFC
Net Income = (SPU  Q) - (VCPU  Q) – Fixed Costs
Net Income = Q(SPU –VCPU) – Fixed Costs
Net Income + Fixed Costs = Q  CMPU
At BEP net income is zero. Therefore;
Q = Fixed Cost  Contribution Margin11/09/2022
Per unit
 The formula:

15

 BEP in units = Total Fixed Costs

Contribution Margin Per unit

 BEP in Birr = Total Fixed Costs

Contribution Margin Ratio

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 The calculation in the equation method and the

calculation in the contribution margin method
appear similar because one equation is merely a
restatement of the other.
 In our example, fixed costs are Br 10,500 and the
contribution margin per unit is Br 60 (Br 120 – Br
60). Therefore;
 BEP in Units = Br 10,500  Br 60 = 175 Units

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 To calculate the break even in terms of dollars/

revenue, in our example, CM% is Br 60  Br 120 =
0.50 or 50% , that is 50% of each dollar of
sales/revenue or 50 cents, is contribution margin.
 To break even, contribution margin must equal
fixed cost of Br 10,500.
 Therefore, to earn Br 10,500 of contribution
margin, revenue/sales must equal to Br 10,500 
0.50 = Br 21,000.
 BEP in Dollars = Br 10,500  0.50 = Br 21,000.
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 3. Graphical Method
18

 The effective way to find the break-even point

is to prepare a break-even graph.
 Because this graph shows costs, volumes and

profits, it is referred to as a cost-volume-profit

graph.
 In the graph, sales volume is recorded along

the horizontal axis, and both total revenues

and total costs (FC + VC) are recorded on the
vertical axis.
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 The construction of the graph using the previous example
data is as follows:
1. Plot the total revenue line, starting at the zero activity level.
For every unit sold, the total revenue increases by Br 120.
2. Plot the total fixed costs using a horizontal line. This line is
plotted at Br 10,500.
3. Plot the total cost line. This starts at the fixed cost line at zero
level of activity. It increases by the variable cost at each
level of activity.
4. Determine the Break-Even-Point from the intersection of the
total cost line and the total revenue line. The BEP in dollars
is found by drawing a horizontal line from BEP to the
vertical axis. The BEP in units is found by drawing a
vertical line from BEP to the horizontal axis.11/09/2022
 Illustration: CVP Income Statement -
20

The CVP income statement for Vargo Video

Company is illustrated below:

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Break-Even Analysis
 Vargo Company’s contribution margin per unit is $200
(sales price $500 - $300 variable costs)
 It was also shown that Vargo Company’s contribution
margin ratio was:

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 Break Even Analysis
22

 Vargo Company’s break-even point in units or in dollars

(using contribution margin ratio) is:

In its early stages of operation, a company’s primary goal

is to break-even.
Failure to break-even will eventually lead to financial
failure
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 Target Net Income
23

 Management usually sets an income objective for

individual product lines.
 The objective is called Target Net Income.
 The target net income indicates the sales necessary
to achieve a specified level of income.
 The sales necessary to achieve target net income
can be determined from each of the approaches
used to determine Break-Even sales.

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 Target Net income
24

 Once a company achieves break-even sales, a sales goal can

be set that will result in a target net income
 Assuming Vargo’s target net income is $250,000, required
sales in units and dollars to achieve this are:

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 Margin of Safety

25

 The margin of safety tells us how far sales can drop before
the company will operate at a loss
 The margin of safety can be expressed in dollars or as a
ratio
 Assuming Vargo’s sales are $800,000:

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 CVP and Changes in the Business Environment

26

 To better understand CVP analysis, three independent

cases involving Vargo company will be examined.
 Each case will use the original data for Vargo Company:

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27

When Vargo Company match a competitor’s 10% discount

and reduce selling price to $450 per unit, what will be the
new break even point?
With variable costs per unit unchanged, a 10% discount in
selling price will decrease the contribution margin to $150
and increase break-even sales to 1,333 units

Management must decide how likely it is that Vargo can

achieve the increase in sales as well as the likelihood of lost
sales if the discount is not matched.
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 Use of new equipment is being considered that will increase

fixed costs by 30% and lower variable costs by 30%. What
effect will the new equipment have on the sales required to
break-even?
 Fixed costs will increase $60,000 and variable costs will
decrease $90,000 (variable cost per unit =$210).

The change appears positive as break-even point is reduced by

approximately 10%
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 Vargo’s supplier of raw materials has increased the cost of

raw materials which will increase the variable cost per unit
by $25.
 Management will not change the selling price of the DVDs.
 Management intends to cut fixed costs by $17,500
 Vargo currently has a net income of $80,000 on sales of
1,400 DVDs
 How many more units will need to be sold to maintain the
$80,000 net income?

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 Variable cost per unit increases to $325 as a result of the

$25 increase in raw materials cost
 Fixed costs decrease to $182,500
 Contribution margin per unit is now $175

 If Vargo cannot sell an additional 100 units, management

must further reduce costs, increase the selling price of the
DVDs, or accept a lower net income. 11/09/2022
 Example 1
31

 Assume a firm has Br. 1,000,000 invested in its plant and sets a
goal of 15% annual return on investment. Fixed costs in the factory
presently amount to Br. 400,000 per year and variable costs amount
to Br. 15 per unit produced. In the past year the firm produced and
sold 50,000 units at Br. 25 each and earned a profit of Br. 100,000.
Required: what will be the value of the following factors to achieve the
target profit level
1. What will be the fixed cost to achieve the target profit level.
2. What would be the variable cost per unit
3. What would be the quantity to be sold
4. What would be the amount of selling price per unit

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sales – variable cost – fc = profit

Sales – varaible cost = profit + FC
50,000.25-50,000V = 550,000
-50,000v = - 700,000
V = 700/50
= 14 per unit

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 PQ – VQ –FC = Profit
 PQ – VQ = Profit + FC
 Q(P-V) = Profit + FC
 Q = Profit + FC
P- V
55,000

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 PQ – VQ = Profit + FC
 PQ = VQ + Profit + FC
 P = V Q + Profit + FC
Q
= 26

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 Example 2
35

2. A factory manufacturing sewing machines has the

capacity to produce 500 machines per annum. The
marginal ( variable cost) of each machine is Br. 200
and each machine is sold for 250. Fixed overheads
are Br. 12,000 per annum. Calculate the break even
points for out put and sales and show what profit
will result if output is 90% of capacity?

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 Limitations of CVP Analysis
36

1. Cost classification as variable and fixed.

2. Selling price remain constant and linear.
3. Variable cost remain constant and linear.
4. Fixed costs remain constant.
5. Sales mix remain constant.

End of Chapter 7

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