HMCost3e PPT Ch16

COST-VOLUME-PROFIT
ANALYSIS
CHAPTER 16
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CHAPTER 16 OBJECTIVES
1. Determine the number of units and amount of sales

revenue needed to break even and to earn a target
profit
2. Determine the number of units and sales revenue
needed to earn an after-tax target profit
3. Apply cost-volume-profit analysis in a multiple-
product setting
CHAPTER 16 OBJECTIVES
4. Prepare a profit-volume graph and a cost-volume-

profit graph, and explain the meaning of each
5. Explain the impact of risk, uncertainty, and changing
variables on cost-volume-profit analysis
6. Discuss the impact of non-unit cost drivers on cost-
volume-profit analysis
THE BREAK EVEN POINT AND TARGET
PROFIT IN UNITS AND SALES REVENUE
Cost-Volume-Profit (CVP) Analysis

•Powerful tool for planning and decision making
• As it emphasizes the interrelationships of costs, quantity sold, and
price, it brings together all of the financial information of the firm
LO-1
• Two frequently used approaches to finding the break-

even point
• Operating income approach
• Contribution margin approach
• Break-even point: the point of zero profit
LO-1
• First step in implementing a units-sold approach to

CVP analysis is to determine just what a unit is
• Second step is to separate costs into fixed and
variable components
• CVP focuses on the firm as a whole
• All costs of the company—manufacturing, marketing, and
administrative—are taken into account
LO-1
Basic Concepts for CVP Analysis

•A useful tool for organizing the firm’s costs into fixed and
variable categories is the contribution-margin-based income
statement
• Operating income: income before income taxes (includes only
revenues and expenses from the firm’s normal operations)
• Net income: operating income minus income taxes
LO-1
The Equation Method for Break-Even and Target

Income
Operating income = Sales revenues – Variable expenses – Fixed
expenses
Operating income = (Price × Number of units) – (Variable cost
per unit × Number of units) – Total fixed costs
LO-1
The Equation Method for Break-Even and Target

Income
•Equation for a target profit put in terms of units
Units for a target profit = (Total fixed cost + Target
income)/(Price - Variable cost
per unit)
•Break-even equation when target income is zero

Break-even units = (Total fixed cost + 0)/Price - Variable cost
per unit
LO-1
Contribution Margin Approach

•Contribution margin is sales revenue minus total variable costs
•By substituting the unit contribution margin for price minus
unit variable cost in the operating income equation, the
following break-even expression is obtained
• Number of units = Fixed costs/Unit contribution margin
LO-1
EXHIBIT 16.1—DIVISION OF REVENUE INTO
VARIABLE COST AND CONTRIBUTION MARGIN
LO-1
Break-Even Point and Target Income in Sales

Revenue
•A units sold measure can be converted to a sales-revenue
measure by multiplying the unit sales price by the units sold
•To calculate the break-even point in sales revenue, variable
costs are defined as a percentage of sales rather than as an
amount per unit sold
•The contribution margin ratio is the proportion of each sales
dollar available to cover fixed costs and provide for profit
LO-1
Sales-Revenue Approach
Operating income = Sales – Variable costs – Total fixed costs
Operating income = Sales – (Variable cost ratio × Sales) – Total
fixed costs
Operating income = Sales (1- Variable cost ratio) – Total fixed
costs
Operating income = Sales × Contribution margin ratio – Total
fixed costs
LO-1
Sales-Revenue Approach
Sales = (Total fixed costs + Operating income)/ Contribution
margin ratio
At break even, operating income equals zero

Break-even sales = Total fixed costs/Contribution margin ratio
LO-1
AFTER TAX PROFIT TARGETS
• When calculating the break-even point, income taxes

play no role because the taxes paid on zero income
are zero
• The after-tax profit, or net income, is computed by
subtracting income taxes from the operating income
(or before-tax profit)
Operating Income = Net income /(1-tax rate)
LO-2
MULTIPLE PRODUCT ANALYSIS
• Direct fixed expenses: fixed costs that can be traced

to each segment and would be avoided if the segment
did not exist
• Common fixed expenses: fixed costs that are not

traceable to the segments and that would remain even
if one of the segments was eliminated
LO-3
MULTIPLE PRODUCT ANALYSIS
Break-Even Point in Units for the Multiple-Product

Setting
Break-even sales = Fixed costs/Contribution margin ratio

•Sales mix is the relative combination of products being sold by
a firm
• Defining a particular sales mix allows us
to convert a multiple-product problem to a
single-product CVP format
LO-3
GRAPHICAL REPRESENTATIONS OF CVP
RELATIONSHIPS
The Profit-Volume Graph

•Portrays the relationship between profits and sales volume
•The graph of the operating income equation [Operating income
= (Price × Units) – (Unit variable cost × Units) – Fixed Costs]
•Operating income is the dependent variable and number of
units is the independent variable
LO-4
EXHIBIT 16.2—PROFIT VOLUME GRAPHS
LO-4
GRAPHICAL REPRESENTATIONS OF CVP
RELATIONSHIPS
The Cost-Volume-Profit Graph

•Depicts relationships among cost, volume, and profits
•To obtain the more detailed relationships, it is necessary to
graph two separate lines
• The total revenue line; revenue = price × units
• The total cost line; (unit variable cost × units) + Fixed costs
•Vertical axis is measured in dollars and horizontal axis is
measured in units sold
LO-4
EXHIBIT 16.3—COST-VOLUME-PROFIT
GRAPH
LO-4
ASSUMPTIONS OF COST-VOLUME-PROFIT
ANALYSIS
Assumptions of Cost-Volume-Profit Analysis

•A linear revenue function and a linear cost function
•Price, total fixed costs, and unit variable costs can be accurately
identified and remain constant over the relevant range
•What is produced is sold
•For multiple-product analysis, the sales mix is assumed to be
known
•The selling price and costs are assumed to be known with
certainty
LO-4
EXHIBIT 16.4—COST AND REVENUE
RELATIONSHIPS
LO-4
EXHIBIT 16.5—SUMMARY OF EFFECTS OF
ALTERNATIVE 1
LO-5
ALTERNATIVE 2
LO-5
ALTERNATIVE 3
LO-5
CHANGES IN THE CVP VARIABLES
Margin of Safety
•Units sold or expected to be sold or the revenue earned or
expected to be earned above the break-even volume
•If a firm’s margin of safety is large given the expected sales for
the coming year, the risk of suffering losses should sales take a
downward turn is less than if the margin of safety is small
LO-5
Operating Leverage
•Use of fixed costs to extract higher percentage changes in
profits as sales activity changes
•The greater the degree of operating leverage, the more that
changes in sales activity will affect profits
•The mix of costs than an organization chooses can have a
considerable influence on its operating risk and profit level
Degree of operating leverage = Total contribution margin/Profit
LO-5
Sensitivity Analysis and CVP

•A what-if technique that examines the impact of changes in
underlying assumptions on an answer
•It is relatively simple to input data on prices, variable costs,
fixed costs, and sales mix and set up formulas to calculate
break-even points and expected profits
•Then, the data can be varied as desired to see what impact
changes have on the expected profit
LO-5
EXHIBIT 16.8—DIFFERENCES BETWEEN
MANUAL AND AUTOMATED SYSTEMS
LO-5
CVP ANALYSIS AND NON-UNIT COST
DRIVERS
• Conventional CVP analysis assumes that all costs can

be divided into variable and fixed costs
• Costs are assumed to be a linear function of sales volume
• An activity-based costing (ABC) system divides costs
into unit and non unit based categories
LO-6
DRIVERS
Total cost = Fixed costs + (Unit variable cost ×

Number of units) + (Setup cost ×
Number of setups) + (Engineering cost
X Number of engineering hours)
LO-6
DRIVERS
Operating income = Total revenue – [Fixed costs +

(Unit variable cost × Number
of units) + (Setup cost ×
Number of setups) +
(Engineering cost × Number
of engineering hours)]
LO-6
DRIVERS
Break-even units = [Fixed costs + (Setup cost ×

Number of setups) +
(Engineering cost × Number of
engineering hours)]/Price – Unit
variable cost)
LO-6
DRIVERS
Differences Between ABC Break-Even Point and

Conventional Break-Even Point
•The fixed costs differ
•The numerator of the ABC break-even equation has two non
unit-variable cost terms
LO-6
END OF CHAPTER 16

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COST-VOLUME-PROFIT

1. Determine the number of units and amount of sales

4. Prepare a profit-volume graph and a cost-volume-

Cost-Volume-Profit (CVP) Analysis

• Two frequently used approaches to finding the break-

• First step in implementing a units-sold approach to

Basic Concepts for CVP Analysis

The Equation Method for Break-Even and Target

The Equation Method for Break-Even and Target

•Break-even equation when target income is zero

Contribution Margin Approach

Break-Even Point and Target Income in Sales

At break even, operating income equals zero

• When calculating the break-even point, income taxes

• Direct fixed expenses: fixed costs that can be traced

• Common fixed expenses: fixed costs that are not

Break-Even Point in Units for the Multiple-Product

Break-even sales = Fixed costs/Contribution margin ratio

The Profit-Volume Graph

The Cost-Volume-Profit Graph

Assumptions of Cost-Volume-Profit Analysis

Degree of operating leverage = Total contribution margin/Profit

Sensitivity Analysis and CVP

• Conventional CVP analysis assumes that all costs can

Total cost = Fixed costs + (Unit variable cost ×

Operating income = Total revenue – [Fixed costs +

Break-even units = [Fixed costs + (Setup cost ×

Differences Between ABC Break-Even Point and

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