MBA 649 Strategic Managerial Accounting & Control

Week 5

Chapter 7 Cost-Volume-Profit Analysis

Dr. Yijing Jiang

Department of Accountancy
Roadmap To understand product costing

Direct materials
Product Costs Direct labor
Overhead

Cost behavior
To use

• Cost-volume-profit analysis
• Relevant information in decision making
• Pricing
• Etc.…

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Profitability Analysis in Financial Accounting

• ROA, ROI, EBITDA, etc.…

• Compare across firms; compare to the peer firms
• Using historical accounting information

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Profitability Analysis in Managerial Accounting
 A different standpoint…

 Part of the planning process to help managers to identify ways to

optimize profitability as it relates to projects, plans, or product levels

 E.g.,
 Cost-volume-profit analysis
 Customer profitability analysis
 Make-or-buy (outsourcing)
 Etc.

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 Cost-Volume-Profit Analysis:
An Overview

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Cost-Volume-Profit Analysis: Overview

 Expresses relationship among costs, volume, and the company’s profit

 Determine sales volume needed to break even or earn a target profit
Cost-Volume-Profit Analysis: Overview

Sales Revenue Price x units

Variable costs x units
Less: Cost of Goods Sold
Fixed costs
Gross Margin
Variable costs x units
Less: Operating Expenses
Fixed costs
Operating Income

Within relevant range, fixed costs are constant regardless of production and sales level.
At what sales level do we break-even?
Cost-Volume-Profit Analysis: Overview

Sales Revenue Price x units

Variable costs x units
Less: Cost of Goods Sold Less: Variable costs x units
Fixed costs
Gross Margin Less: Fixed costs
Variable costs x units
Less: Operating Expenses Operating Income
Fixed costs
Operating Income

If sales revenue after deducting variable costs covers total fixed

costs, I break-even; sales beyond that level contributes to profits!
Assumptions Underlying CVP Analysis
 The behavior of total revenue is linear
 The behavior of total costs is linear
 In multiproduct organizations, the sales mix remains constant
 The inventory levels at the beginning and end of the period are the
same
 # produced = # sold

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 Contribution Margin

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Contribution Margin
 Contribution margin: excess of sales revenue over variable expenses
 Unit contribution margin: excess of the selling price per unit over the
variable cost per unit
Unit Contribution Margin Example – Kay’s Posters
Kay has an online poster business. She currently sells each poster for $35,
while each poster has a variable cost of $21. Kay has monthly fixed costs
of $7,000. The relevant range is 0 to 2,000 posters and Kay is currently
selling 550 posters.
Unit Contribution Margin Example – Kay’s Posters

 Sales price per unit $35

 Less: Variable costs per unit ($21)
 Unit contribution margin $14

 Interpretation:
 Kay earns $14 every time she sells a poster that can be used to:
 Cover fixed costs
 Earn a profit
Contribution Margin Ratio
Ratio of contribution margin to sales revenue
 Unit contribution margin ÷ unit price
 Contribution margin ÷ sales revenue

 Kay’s CM ratio:
60% of revenue is 40% of revenue 
 $14 ÷ $35 = 40% variable costs fixed costs + profit
 $7,700 ÷ $19,250 = 40%
Contribution Margin – Key Take-aways
 The contribution margin represents the portion of a product’s sales
revenue that isn’t used up by variable costs, and so contributes to
covering fixed costs.
 The application can be flexible……

Apple Mac Division

“How each product line contributes to cover the

divisional fixed costs?”
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Contribution Margin – Key Take-aways
 The contribution margin represents the portion of a product’s sales
revenue that isn’t used up by variable costs, and so contributes to
covering fixed costs.
 The application can be flexible……

Tim Cook

“How each division contributes to cover the

corporation-wide costs?”
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Break-Even Point

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The Break-Even Point
 The sales level at which operating income is zero
Break-Even Point Calculation –
The Income Statement Approach

Kay’s poster example:

Break-Even Point Calculation –
Using Unit Contribution Margin

Shortcut formula:

Kay’s example:
Sales in units = ($7,000 + $0) ÷ $14 = 500 posters
Break-Even Point Calculation –
Using Contribution Margin Ratio

Shortcut formula:

Kay’s example:
Sales in dollars = ($7,000 + $0) ÷ 40% = $17,500
Break-Even Point Applications
 Business: to determine the lowest amount of business activity
necessary to prevent losses
 Investing: when the market price of an asset is the same as its costs,
we call it “break-even”
 NPOs:
 Cornell University: “Break-even analyses figure prominently in any
discussion of new programs. Although we have programs that operate at a
loss because of their importance educationally, overall our cash inflows
have to be sufficient to support our total program.”

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Break-Even Point – Key Take-aways
 A useful tool to study the relationship between revenues, variable costs,
and fixed costs
 The major benefit: it indicates the lowest amount of business activity
necessary to prevent losses

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An Application of Break-Even –
Oil & Gas Industry

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International Monetary Fund’s Break-Even Estimations

• Focuses on price (not quantity)

*MENAP: the Middle East and North Africa • Country-level
• Interpretation: the oil price necessary to
balance the budget of the country
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Break-Even Price for major U.S. Oil Fields f Sco p
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CVP Analysis – Existing Wells vs. New Wells
450,000 Accounting for oil 450,000
exploration expenses:
Full cost method
400,000 400,000
• All costs are capitalized first
350,000 • Amortization starts
350,000 with production
• Different cost structure for existing wells and new wells
300,000 300,000

250,000 250,000
penses
Tot al ex
Dollars

Dollars
200,000 200,000

penses
150,000
Tot al ex 150,000
Fixed expenses
100,000 100,000

50,000 Fixed expenses 50,000

100 200 300 400 500 600 700 800 100 200 300 400 500 600 700 800
Units Units

Existing Wells New Wells

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CVP Analysis – Existing Wells vs. New Wells
450,000 450,000

400,000 400,000

350,000 350,000 ir ce
p
300,000 300,000 l es
r ice : s a
s p e
250,000
a le 250,000
l op
s S
Dollars

Dollars
:
200,000 pe 200,000
Slo
150,000 150,000

100,000 100,000

50,000 50,000

100 200 300 400 500 600 700 800 100 200 300 400 500 600 700 800
Units Units
Existing Wells New Wells
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Oil Price in 2020

Bounced back, but remained low in 2020

https://www.nytimes.com/2020/04/20/business/oil-prices.html
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OPEC Production

Data source: https://www.opec.org/opec_web/en/publications/338.htm

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How About Companies in U.S. and Canada?
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• Small companies with risky financial

structures struggled
• Large corporations with strong balance
sheets got good deals

https://www.mckinsey.com/industries/oil-and-gas/our-insights/mergers-in-a-low-oil-price-
environment-proceed-with-caution
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A Wave of M&As in Oil & Gas Industry in 2020
Cost-Volume-Profit Analysis

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Graphing Cost-Volume-Profit Relationships

Consider the following information for Curl, Inc.:

Cost-Volume-Profit Graph

450,000

400,000

350,000

300,000

250,000
Dollars

200,000
se s
x p en
150,000 ot a le
T
100,000
Fixed expenses

50,000

100 200 300 400 500 600 700 800

Units
 Cost-Volume-Profit Graph

450,000

400,000
le s
350,000 l s a
o ta
T
300,000

250,000
Dollars

200,000
se s
p e n
le x
150,000
Tot a
100,000
Fixed expenses

50,000

100 200 300 400 500 600 700 800

Units
Cost-Volume-Profit Graph

450,000

400,000
le s
l s a a
350,000
a re
Break-even Tot fi t a
300,000
point Pr o
250,000
Dollars

200,000
ns es
x p e
150,000 ot a le
T
Fixed expenses
r ea
100,000
s a
50,000
L os

100 200 300 400 500 600 700 800

Units
Cost-Volume-Profit Graph
450,000

400,000
le s
350,000 l s a
a
Tot
300,000

250,000
Dollars

200,000
se s
x p en
150,000 ot a le
T
Fixed expenses
100,000

50,000

100 200 300 400 500 600 700 800

Units
How about stepwise costs?
Stepwise costs are approximated as variable costs in CVP analysis
Applying CVP Analysis

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Applying CVP – Target Net Profit

 How many products Curl, Inc. must sell to earn a profit of $100,000?

Fixed expenses + Target profit Units sold to earn

Unit contribution margin the target profit

$80,000 + $100,000
= 900 surfboards

$200 = 900 surfboards

Applying CVP – Safety Margin
 Safety margin: the difference between actual sales revenue and break-
even sales revenue

What is the company’s safety margin at sales of $250,000?

100 units of products, or $50,000 sales.
Applying CVP – Additional Costs
 Curl, Inc. sells 500 surfboards per year
 If we increase annual advertising budget by $10,000, we expect the
sales to increase to 540 units,
 Should we increase advertising?

40 units additional sales  40x$200 = an increase of $8,000 in

CM, which is less than the advertising cost of $10,000
CVP Analysis
with Multiple Products

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CVP Analysis with Multiple Products
 With more than one product, sales mix is the relative combination in
which a company’s products are sold
 Assume Curl sells surfboards and sailboards:
 What is the break-even point?

Based on historical data, the ratio of

surfboards and sailboards is 5:3
CVP Analysis with Multiple Products
 Weighted average contribution margin: the average of the several
products’ unit contribution margin, weighted by the relative sales
proportion of each product.

321 surfboards, 193 sailboards.

Contribution Income Statement

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Contribution Format Income Statement

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Contribution Format Income Statement
 Highlights the distinction between variable and fixed expenses.
 Facilitates management control functions of planning, control, and
decision making.

(Contribution Income Statements for planning and budgeting)

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Cost Structure
and Operating Leverage

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Operating Leverage
 Operating leverage: the extent to which an organization uses fixed
costs in its cost structure.
 Operating leverage factor shows the firm’s operating leverage at a
particular sales volume.

Operating income

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Operating Leverage
 Operating leverage measures how a percentage change in sales will
affect percentage change in profits, at a given sales level.

Percent increase in sales

10%
Operating leverage factor X 5
Precent increase in profits
50%

 On the other side, the higher the operating leverage, the greater the
potential danger from forecasting risk.
 A relatively small error in forecasting sales can be magnified in to large
errors.

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Effect of Income Taxes

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Effect of Income Taxes
 Income taxes affect a company’s CVP relationships
 To earn a particular after-tax net income, a greater before-tax income
will be required

Target after-tax net income Before-tax

1 - tax rate = net income