Cost-Volume-Profit (CVP) Relationships

Analysis

Contribution Margin Analysis

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• This analysis is based on the fact that:

• For each volume of production (sale) there is certain

amount of cost and in turn certain amount of profit so that if
we change the volume of production, the amount of cost
and in turn the amount of profit will change.
• Therefore, if we know the behavior (way of change) of both
costs and profits as we change the volume of production, it
is possible to determine the volume of production (sales)
that minimize the cost and maximize the profit for a
certain period of time.

• This type of analysis is called:

Cost-Volume-Profit (CVP) Relationships Analysis
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• It is clear from the above definition that Cost-Volume-Profit
Analysis is based on a basic assumption that:
• Changes in the volume of production (sales) is the only factor
that affect the behavior of both costs and profits.
• Therefore, the results of this analysis should not be finalized
before considering other factors that affect the behavior of
costs and profits such as:
• Advertising budget.
• After sales services.
• Changes in the market conditions.
• Competitors reactions.
• Etc. 3
• Cost-Volume-Profit Relationships Analysis is based on the
interaction between 5 elements :
1- Selling Prices (constant).
2- Production (= Sales) Volume (inventories do not change).
3- Variable Cost Per Unit.
4- Total Fixed Cost.
5- Sales Mix Produced and Sold (constant).
• Cost-Volume-Profit Relationships Analysis is using the
Income statement of the Variable cost approach to explain:
• The effect of changes in the Selling Price, Production
(Sales) Volume, Variable Cost Per Unit, Total Fixed Cost,
and Sales Mix on the profit. 4
 Contribution margin (CM)
• Contribution margin is defined as sales less variable costs.
• Then Contribution margin is used to cover fixed expenses.
• Any remaining contribution margin after covering fixed
costs contributes to net operating income.
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 CM= sales revenue-variable costs

Number of units × selling price Number of units × variable cost/unit

CM per unit= selling price per unit – variable cost per unit
CM ratio= contribution margin ÷ sales revenue
Or 1- variable cost ratio
Variable cost ratio= variable cost ÷ sales revenue

If sales revenue equals zero, the contribution margin is zero,

and the company generates losses equal to fixed costs.

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• To explain this point assume that:
• Selling Price (SP) / unit = 500 LE
• Variable Cost / unit = 300 LE
• Total Fixed Cost = 80000 LE
• Assume that the company now is at the Zero Point (i.e.,
production = sales = zero).

Sales revenue = Variable costs = Contribution margin = zero

Fixed cost = 80,000 LE

• Therefore: The income statement at this point will be as follow:

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• Sales revenue (zero x 500)= zero
• V. cost of sales (zero x 300)= zero
• Contribution Margin = zero
• Fixed Cost = (80000)
• Net Income (Loss) = (80000)

It is clear that there is net loss = fixed cost at the zero point
• Now assume that the company produce and sell one unit.
As a result: Revenue =500, V. Cost =300, CM =500–300=200
• And the income statement of the company appears as
follow:
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• Sales revenue (1 x 500) = 500
• V. cost of sales (1 x 300) = 300
• Contribution Margin = 200
• Fixed Cost = (80000)
• Net Income (Loss) = (79,800)
• Notice that each unit produced and sold will achieve CM = 200 LE.
• This CM is contribute (used) to cover the fixed cost and reduce the
net loss of the company.
• Therefore, if the company produce and sell number of units to
achieve CM enough to cover fixed cost 80000 LE, the company will
be at the break-even point where: assume sales units = 400

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 If the Co. sells 400 units in a month, it will be
.operating at the break-even point
• Sales revenue (400 x 500) = 200,000
• V. cost of sales (400 x 300) = 120,000
• Contribution Margin = 80,000
• Fixed Cost = (80000)
• Net Income (Loss) = 0

• Now any unit produced and sold above the break-even volume
(i.e., above400 units) will achieve net income = CM 200 LE / unit.
• For example, assume that the company produce and sell 401
units, which is 1 unit above the break – even volume.
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 If Co. sells one more bike (401 bikes), net
.operating income will increase by $200

• Sales revenue (401 x 500) = 200,500

• V. cost of sales (401 x 300) = 120,300
• Contribution Margin = 80,200
• Fixed Cost = (80000)
• Net Income = 200
• Notice from the above income statements that:

Sales < 400 Sales = 400 Sales > 400

Net loss Break-Even Net Income
Total R < Total C Total R = Total C Total R > Total C
CM < FC CM = FC CM > FC 11
• Notice that it is easy to expect achieved profit 400 LE if the company
produce and sell 2 units ( 2 units x 200 CM/unit) above the break-
even volume.
• Therefore, we do not need to prepare an income statement to
estimate profits at a particular sales volume. Simply multiply the
number of units sold above break-even by the contribution
margin per unit as follow:
Net Income = (sales units - breakeven units) x CM per unit

• In the above example, each unit sold above the break-even

volume will add 200 LE contribution margin to the net income of
the company.
• Therefore, if the company sells 700 units, its net income will be
700 sales - 400 breakeven x 200 CM = 60000 LE 12
 Contribution Margin Ratio
change in profit as a % of change in sales revenue
Total CM $80,000
CM Ratio = x 100 = x 100 = 40%
Total sales $200,000

$200 x 100 = 40%

CM Ratio = Contribution Margin Per Unit =
Selling Price Per Unit $500

For ach $1.00 increase in sales results in a total contribution

margin increase of 40¢. Or the change in profit = 40% of the
change in sales revenue
For example, if sales revenue increased by $100,000,
Profit increase = 100,000 x 40% = $40,000
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• Changes in Fixed Costs and Sales Volume

• What is the profit impact if Co. can increase unit sales from
500 to 540 by increasing the monthly advertising budget by
$10,000?

• Increase in total CM (540 – 500) x 200 = 40 x 200 = 8,000

• - Increase in FC = (10,000)
• Decrease in Co. profit (2,000)

• Reject, because the proposed plan will decrease the company

profit by (2,000).
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• Change in Variable Costs and Sales Volume

• What is the profit impact if Co. can use higher quality raw materials, thus
increasing variable costs per unit by $10, to generate an increase in unit
sales from 500 to 580?

• Proposed V. cost / unit = $300 + $ 10 = 310

• Proposed CM / unit = $500 – $310 = 190

• Proposed total CM = 580 x 190 = 110,200

• Current total CM = 500 x 200 = (100,000)
• Change in CM (net income) = 10,200
• Accept because the proposed plan will increase the company profit by 10200.

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• Change in Fixed Cost, Sales Price and Volume
• What is the profit impact if Racing (1) cuts its selling price $20
per unit, (2) increases its advertising budget by $15,000 per
month, and (3) increases unit sales from 500 to 650 units per
month?
• Proposed selling price = 500 – 20 = 480
• Proposed CM / unit = 480 – 300 = 180
• Proposed total CM = 650 x 180 = 117000
• Current total CM = 500 x 200 = (100000)
• Increase in CM 17000
• Increase in fixed cost (15000)
• Increase in net income 2000
• Accept because the proposed plan will increase the Co. profit by 2000.
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• Change in Variable Cost, Fixed Cost and Sales Volume
• What is the profit impact if Co. (1) pays a $15 sales commission per bike sold
instead of paying salespersons flat salaries that currently total $6,000 per
month, and (2) increases unit sales from 500 to 575
• Proposed V. cost / unit = 300 + 15 = 315
• Proposed CM / unit = $500 – $315= 185

• Proposed total CM = 575 x 185 = 106375

• Current total CM = 500 x 200 = (100000)
• Increase in CM 6375
• Decrease in fixed cost (saving) 6000
• Increase in net income 12375
• Accept because the proposed plan will increase the company profit by
12375.
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 Break-Even Analysis
The contribution margin method has two key equations.

Break-even volume = Fixed Costs

in units sold (Selling Price – v. cost/unit) = units
contribution margin / Unit
Break-even volume = $80,000
= 400 units
in units sold (500 – 300)
200

Break-even value in Fixed Costs = $

total sales dollars = CM ratio
Break-even value in $80,000
total sales dollars = = $ 200,000
40%
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 Target Profit Analysis
The contribution margin methods can be used to determine the
sales volume needed to achieve a target profit (ex.: $100,000).
Target profit volume= Fixed Costs + Target profit
in units sold (Selling Price – v. cost/unit) = units
contribution margin / Unit
Target profit volume = $80,000 + $100,000
= 900 units
in units sold (500 – 300)
200
Target profit value in Fixed Costs + Target profit = $
total sales dollars = CM ratio
Target profit value in $80,000 + $100,000
total sales dollars = 40%
= $ 450,000
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 The Margin of Safety

 The margin of safety is the excess of sales dollars over

the break-even volume of sales dollars.
 It is the amount by which sales can drop before losses are
incurred. The higher the margin of safety, the lower the risk
of not breaking even and incurring a loss.

Margin of safety in dollars = Total sales - Break-even sales

$ = $450,000 - $200,000 = $ 250,000
% = (250,000/450,000)x100 = 55.6%
Margin of safety in units= sales units - Break-even in units
Units = 900 – 400 = 500 units
% = (500 / 900) x 100 = 55.6 %
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 Cost Structure and Profit Stability
Cost structure refers to the relative proportion of fixed and
variable costs in an organization. Managers often have some
latitude in determining their organization’s cost structure.
There are advantages and disadvantages to high fixed cost (or low
variable cost) and low fixed cost (or high variable cost) structures.
An advantage of a high fixed cost structure is that Companies with
income will be higher in good years compared to low fixed cost
companies with lower proportion of fixed costs. structures enjoy
greater stability
A disadvantage of a high fixed cost structure is
in income
that income will be lower in bad years compared
to companies with lower proportion of fixed costs. across good
and bad years.
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 Operating Leverage
 Is the change in income as a result of minor change in
sales. It is a measure of how sensitive net operating income
is to percentage changes in sales.

Degree of Contribution margin

= = times
operating leverage Net operating income
The degree of operating leverage in our company is 5.

Degree of operating leverage = $100,000 = 5 times

$20,000 22
It means that change in income = 5 times change in sales.
For example, If Racing increases its sales by 10%,
net operating income would increase by 5 x 10% = 50%.
Actual sales Increased
(500) sales (550)
Sales $ 250,000 $ 275,000
Less variable expenses 150,000 165,000
Contribution margin 100,000 110,000
Less fixed expenses 80,000 80,000
Net operating income $ 20,000 $ 30,000

10% increase in sales from

$250,000 to $275,000 . . .
. . . results in a 50% increase in
income from $20,000 to $30,000.

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 Therefore, which one is better depends on the future sales:
 If we expect stable or decrease in sales, company (A) is better to
gain the advantage of early profit and stability
 If we expect increase in sales, company (B) is better to gain the
advantage of profitability
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 Exercise

Farah Company manufactures and sells a specialized cordless

telephone for high electromagnetic radiation environments. The
company’s contribution format income statement for the most recent
year is given below:

Management is anxious to increase the company’s profit and

has asked for an analysis of a number of items.
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Required:
1. Compute the company’s CM ratio and variable expense ratio.
2. Compute the company’s break-even point in both units and sales
dollars. Use the equation method.
3. Assume that sales increase by $400,000 next year. If cost behavior
patterns remain unchanged, by how much will the company’s net
operating income increase? Use the CM ratio to compute your answer.
4. Refer to the original data. Assume that next year management wants
the company to earn a profit of at least $90,000. How many units will
have to be sold to meet this target profit?
5. Refer to the original data. Compute the company’s margin of safety in
both dollar and percentage form.
6. a. Compute the company’s degree of operating leverage at the present
level of sales.
b. Assume that through a more intense effort by the sales staff, the
company’s sales increase by 8% next year. By what percentage would

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 you expect net operating income to increase? Use the degree of
operating leverage to obtain your answer.
c. Verify your answer to ( b ) by preparing a new contribution format
income statement showing an 8% increase in sales.
7. In an effort to increase sales and profits, management is considering
the use of a higher-quality speaker. The higher-quality speaker would
increase variable costs by $3 per unit, but management could
eliminate one quality inspector who is paid a salary of $30,000 per
year. The sales manager estimates that the higher-quality speaker
would increase annual sales by at least 20%.
a. Assuming that changes are made as described above, prepare a
projected contribution format income statement for next year.
Show data on a total, per unit, and percentage basis.
b. Compute the company’s new break-even point in both units and
dollars of sales. Use the formula method.
c. Would you recommend that the changes be made?
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8- A company is producing and selling a product with the following data:
Sales (15000 units × $30) $ 450 000
Variable cost of sales 315 000
Contribution Margin 135 000
Fixed Costs 90 000
Net Income 45 000
Required:
1 - Explain using numbers the reason for achieving the given net income?
2 - The sales manager is convinced that a 10% reduction in the selling price,
combined with paying sales commission 2 $/unit instead of paying $40000
sales salaries will cause unit sales to double. Do you agree? Why?
3 - Refer to the original data with sales 15 000 units, assume that
automating the operations of the company could reduce variable costs by $
8 per unit and increase the fixed costs by $ 135 000. Do you recommend
automation? Why?
4 - What is the volume that makes both the current and the automated
process equal? Then show the sales range that is relevant for the current
process and the sales range that is relevant to the automated process. 28