Management Accounting

CVP Analysis
What is CVP?

CVP (Cost Volume Profit) analysis explores the relationship

between revenue, cost and volume and its effect on profit.

2
 Foundational Assumptions in CVP

1. Changes in production/sales volume are the sole cause for

cost and revenue changes
2. Total costs consist of fixed costs and variable costs
3. Revenue and costs behave and can be graphed as a linear
function (a straight line)
4. Selling price, variable cost per unit and fixed costs are all
known and constant
5. In many cases only a single product will be analyzed. If
multiple products are studied, their relative sales proportions
are known and constant
6. The time value of money (interest) is ignored

3
Profit Equation

4
CVP: Contribution Margin

• Manipulation of the basic equations yields an extremely

important and powerful tool extensively used in Cost
Accounting: the Contribution Margin
• Contribution Margin equals sales less variable costs
CM = S – VC
• Contribution Margin per Unit equals unit selling price less
variable cost per unit
CMu = SP – VCu

5
Contribution Margin, continued

• Contribution Margin also equals contribution

margin per unit multiplied by the number of units
sold (Q)
• CM = CMu x Q
• Contribution Margin Ratio (percentage) equals
contribution margin per unit divided by Selling Price
• CMR = CMu ÷ SP
• Interpretation: how many cents out of every sales dollar
are represented by Contribution Margin

6
Basic Formula Derivations

The Basic Formula may be further rearranged and

decomposed as follows:
Sales – VC – FC = Operating Income (OI)
(SP x Q) – (VCpu x Q) – FC = OI
Q (SP – VCpu) – FC = OI
Q (CMpu) – FC = OI

7
 Breakeven Point

• Recall the last equation in an earlier slide:

• Q (CMpu) – FC = OI
• A simple manipulation of this formula, and setting OI
to zero will result in the Breakeven Point (quantity):
• BEQ = FC ÷ CMpu
• At this point, a firm has no profit or loss at the given
sales level
• If per-unit values are not available, the Breakeven
Point may be restated in its alternate format:
• BE Sales = FC ÷ CMR

8
Breakeven Point, extended:
Profit Planning

With a simple adjustment, the Breakeven Point

formula can be modified to become a Profit Planning
tool.

Profit is now reinstated to the BE formula, changing it

to a simple sales volume equation
Q = (FC + OI)
CM

9
CVP Graphically

10
Profit Planning, Illustrated

11
CVP and Income Taxes

• From time to time it is necessary to move back and forth

between pre-tax profit (OI) and after-tax profit (NI),
depending on the facts presented
• After-tax profit can be calculated by:
OI x (1-Tax Rate) = NI
• NI can substitute into the profit planning equation through
this form:
• OI = NI .
(1-Tax Rate)

12
Segregation of Mixed Cost

• All costs should be broken in fixed and variable components

• In case of mixed costs (i.e including fixed and variable both)
they have to be segregated.
• Additional cost of manufacturing one additional unit is called
the marginal cost or variable cost

Eg: A transporter may charge a fixed amount of Rs.1000 per

month regardless of the quantity transported plus Rs.5/-kg of
material transported.

13
Segregating semi variable overhead

Two point method

Comparison of output at two different levels with corresponding
level of semi variable expenses

Eg: The total cost to produce

20000 units = Rs.16 lacs
40000 units = Rs.20 lacs

Find the fixed cost and variable cost

14
Variable cost = 20 lac – 16 lacs = 4 lacs = Rs.20pu
40000 – 20000 20000

Fixed cost @ 20,000 units = 16 lacs – (Rs.20* 20000 units)

= 16 lacs – 4 lacs = 12 lacs

Fixed cost @ 40,000 units = 20 lacs – (Rs.40* 20000 units)

= 20 lacs – 8 lacs = 12 lacs

15
Margin of Safety

• One indicator of risk, the Margin of Safety (MOS) measures

the distance between budgeted sales and breakeven sales:
• MOS = Budgeted Sales – BE Sales
• The MOS Ratio removes the firm’s size from the output, and
expresses itself in the form of a percentage:
• MOS Ratio = MOS ÷ Budgeted Sales

16
Bridal Shoppe sells wedding dresses. The cost of each dress is
comprised of the following: Selling price of Rs10,000 and variable
(flexible) costs of Rs.4,000. Total fixed (capacity-related) costs for Bridal
Shoppe are Rs.9,00,000.

1. What is the contribution margin per dress?

2. What is the Bridal Shoppe’s total profit when 200 dresses are sold?
3. How many dresses must Bridal Shoppe sell to reach the breakeven
point?
4. How many dresses must Bridal Shoppe sell to yield a profit of
Rs.6,00,000?

17
What is the contribution margin per dress?

Revenues – Flexible Costs = CM

10,000 - 4000 = Rs.6000

What is the Bridal Shoppe’s total profit when 200 dresses are sold?

Revenues – Variable Costs – Fixed Costs = Total Profit

200 (10,000) – 200(4000) – 9,00,000 = Rs.3,00,000

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How many dresses must Bridal Shoppe sell to reach the breakeven
point?
X = Fixed Costs/Contribution Margin
X = 9,00,000/6000
X = 150 dresses

How many dresses must Bridal Shoppe sell to yield a profit of Rs.
6,00,000?
Total Revenues – Total Costs = Total Profit
10,000X - 4000X – 9,00,000 = 6,00,000
6000X = 15,00,000
X = 15,00,000/6000
X = 250 dresses

19
A factory manufacturing sewing machines has the capacity to
produce 500 machines per annum. The variable cost of each
machine is Rs.200 and each machine is sold for Rs.250. Fixed
overhead are Rs.12,000 per annum.

i) Calculate the Break even point for output and sales

ii) Show what profit will result if output is 90% of capacity?

20
Contribution = 250 – 200 = Rs.50

P/V ratio = 50/250 = 20%

BEP = FC / Cont.pu = 12,000/50 = 240 machines

BES = 240 * Rs.250 = Rs.60,000

or
FC / PV ratio = 12000/20% = Rs.60,000

Profit at 90% capacity

At 90% capacity units sold = 500 units * 90% = 450 units

Total contribution = 450 * 50 = Rs.22500

Less : fixed cost Rs.12000
Profit Rs.10500
21
Sales of a product amount to 200 units per month at Rs.10 per
unit. Fixed overhead is Rs.400 per month and variable cost
Rs.6 per unit. There is a proposal to reduce price by 10%.
Calculate the present and future P/V ratios and find by
applying P/V ratios, how many units must be sold to maintain
total profit.

22
 Present Proposed
Selling price 10 9
Variable cost 6 6
Contribution 4 3
P/V ratio 4/10 = 40% 3/9 = 33 1/3 %
Total contribution 200 * 4 = 800 800/3 = 267 units
Fixed cost 400 400
Profit 400 400

Total contribution has to be Rs.800.

Contribution per unit is Rs. 3, hence 800/3 = 267 units to be sold to maintain
the total profit

23
Merry Manufacturers Ltd has supplied you the following
information in respect of one of its products:

Total Fixed costs Rs. 18,000

Total Variable costs Rs. 30,000
Total Sales Rs. 60,000
Units sold 20,000

Find out:
a) Contribution per unit
b) Break even point
c) Margin of safety
d) Profit
e) Volume of sales to earn a profit of Rs.24,000
24
 Total for Per unit
20,000 units
Sales 60,000 3.00
Variable cost 30,000 1.50
Contribution 30,000 1.50
Fixed cost 18,000
Profit 12,000

a) Contribution per unit – Rs.1.50/-

b) Break even point = 18,000/1.50 = 12,000 units
c) Margin of safety = 60,000 – (12000*3) = Rs.24000
d) Profit = Rs.12,000
e) Volume of sales to earn a profit of Rs.24,000 =
(18000 + 24000) / 1.50 = 28000 units

25
Ahmed Khan sells a popular brand of men’s shirt at an average
price of Rs.2800/- each. He purchases the shirts from a supplier at
a unit cost of Rs.1800/-. The costs of operating his shop are all
fixed costs and amount to Rs.54,00,000 a year. He pays
commission to his salesmen at the rate of Rs.100 for every shirt
sold through the particular salesman.

i. How many shirts must be sold in a year to break even?

ii. Compute the sales revenue at the break-even
iii. Compute the monthly sales revenue required to earn a net
profit before tax of Rs.45,00,000 in a year.

26
Selling price = Rs.2800
VC = 1800 + 100 = Rs.1900
Contribution = Rs.900
Fixed cost = Rs.54,00,000

i. How many shirts must be sold in a year to break even?

FC/Cont p.u = 5400000/900 = 6000 shirts
ii. Compute the sales revenue at the break-even
6000 * 2800 = Rs.1, 68,00,000
iii. Compute the monthly sales revenue required to earn a net
profit before tax of Rs.45,00,000 in a year.
(54lacs + 45 lacs)/ 900 = 11,000 units p.a
or 11000 * 2800 = Rs.3,08,00,000
Per month sales = Rs.25,66,667

27
From the following data, calculate:
i. Break-even point in amount of sales in rupees
ii. Number of units that must be sold to earn a profit of
Rs.60,000 per year
iii. How many units must be sold to earn a net income of 10% of
sales?

Selling price Rs.20 per unit

Variable manufacturing costs 11 per unit
Variable selling costs 3 per unit
Fixed factory overheads 5,40,000 per year
Fixed selling costs 2,52,000 per year

28
 Selling price = Rs.20
Variable cost = Rs.11 + 3 = Rs.14
Contribution = Rs.20 – 14 = Rs.6
P/V ratio = 6/20 * 100 = 30%
Total fixed cost = Rs.540000 + 252000 = Rs.7,92,000

i. Break-even point in amount of sales in rupees

FC/Cont margin = 792000/30% = Rs.26,40,000
ii. Number of units that must be sold to earn a profit of Rs.60,000
per year
(FC + desired profit)/Cont.pu = (792000+60000)/6 = 142000units
iii. How many units must be sold to earn a net income of 10% of
sales?
Let number of units sold be x
6x – 792000 = 2x
or 4x = 792000
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or x = 1,98,000 units
Northenscold Company sells several products. Information of average
revenue and costs are as follows:

Selling price per unit $20.00

Variable costs per unit:
Direct materials $4.00
Direct manufacturing labor $1.60
Manufacturing overhead $0.40
Selling costs $2.00
Annual fixed costs $96,000

1. Calculate the contribution margin per unit.

2. Calculate the number of units Northenscold’s must sell each year to
break even.
3. Calculate the number of units Northenscold’s must sell to yield a
profit of $144,000.

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Calculate the contribution margin per unit.

Contribution: $20 - $4 - $1.60 - $0.40 - $2 = $12,

12/20 *100 = 60%

Calculate the number of units Northenscold’s must sell each year to

break even.

20X - 8X - 96,000 = 0; X = 8,000 units

Calculate the number of units Northenscold’s must sell to yield a profit of

$144,000.

20X – 8X – 96,000 = $144,000; X = 20,000 units

Or
(96000 + 144000)/12 = 20000 units

31
The Wardlock Company sold 1,00,000 units of its products at
Rs.20 per unit. Variable costs are Rs.14 per unit. Fixed costs are
Rs.7,92,000.
Determine the following:
1. Breakeven point
2. Number of units to be sold to earn an income of Rs.60,000
before income taxes
3. Number of units to be sold to earn an income of Rs.90,000
after taxes, assuming 40% tax rate.

32
Breakeven point
Fixed cost / Cont. pu = 7,92,000 / 6 = 1,32,000 units

Number of units to be sold to earn an income of Rs.60,000 before income

taxes
If required income before tax is Rs.60,000, required contribution will be
Rs.60,000 + Rs.7,92,000 = Rs.8,52,000
852000/6 = 1,42,000 units

Number of units to be sold to earn an income of Rs.90,000 after taxes,

assuming 40% tax rate
If required income after tax is Rs.90,000
Required income before tax = 90,000/60% = Rs.1,50,000
Required contribution will be Rs.1,50,000 + Rs.7,92,000 = Rs.9,42,000
Rs. 9,42,000/6 = 1,57,000 units

33
Operating Leverage

Operating Leverage -- The use of

fixed operating costs by the firm.

• One potential “effect” caused by the

presence of operating leverage is that a
change in the volume of sales results in a
“more than proportional” change in
operating profit (or loss).
 Impact of Operating leverage on Profits

Firm F Firm V Firm 2F(in thousands)

Sales $10 $11 $19.5
Operating Costs
Fixed 7 2 14
Variable 2 7 3
Operating Profit $ 1 $ 2 $ 2.5
FC/total costs .78 .22 .82
FC/sales .70 .18 .72
 Impact of Operating leverage on Profits

• Now, subject each firm to a 50% increase in

sales for next year.
• Which firm do you think will be more
“sensitive” to the change in sales (i.e., show
the largest percentage change in operating
profit, EBIT)?
[ ] Firm F; [ ] Firm V; [ ] Firm 2F.
 Impact of Operating leverage on Profits

Firm F Firm V Firm (in

2Fthousands)

Sales $15 $16.5 $29.25

Operating Costs
Fixed 7 2 14
Variable 3 10.5 4.5
Operating Profit $ 5 $ 4 $10.75
Percentage Change in EBIT* 400% 100% 330%

* (EBITt - EBIT t-1) / EBIT t-1

 Impact of Operating leverage on Profits

• Firm F is the most “sensitive” firm -- for it, a 50% increase

in sales leads to a 400% increase in EBIT.
• Our example reveals that it is a mistake to assume that
the firm with the largest absolute or relative amount of
fixed costs automatically shows the most dramatic effects
of operating leverage.
• Later, we will come up with an easy way to spot the firm
that is most sensitive to the presence of operating
leverage.
Operating Leverage - Interpretation
• High Operating Leverage: A larger proportion of fixed costs;
more sensitivity to changes in sales.
• Low Operating Leverage: A smaller proportion of fixed costs;
less sensitivity to sales fluctuations.
Question
Solution
 Numerical
Voltar 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:

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. 42
 Solution
Compute the company's CM ratio and variable expense ratio.
CMR = 25%; VC ratio = 75%
Compute the company's break-even point in both units and sales dollars. Use the
equation method.
60 Q = 45Q + 240,000
15 Q = 240,000 -> Q = 16,000 units
16,000 * 60 = $960,000
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.
Increase in sales $400,000
CMR 25%
Increase in NOI $100,000
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?
(240,000 + 90,000)/15 = 22,000 units
Refer to the original data. Compute the company's margin of safety in both dollar
and percentage form.
Margin of safety = 1,200,000 – 960,000 = $240,000 or 20% 43
Numerical

You rent a kiosk in the mall for $300 a month and use it to sell
T-shirts with college logos from colleges and universities all over
the world. You sell each T-shirt for $25, and your cost for each
shirt is $15. You also pay your sales person a commission of
$0.50 per T-shirt sold in addition to a salary of $400 per month.

Construct a contribution margin income statement for two

different months: in one month, assume 100 T-shirts are sold,
and in the other, assume 200 T-shirts are sold.

44
Solution

45
From the following data, you are required to calculate the break-even point and net
sales value at this point:
Rs.
Selling price per unit 25
Direct Material Cost per unit 8
Direct Labour cost per unit 5
Fixed overhead 24,000

Variable overheads @ 60% on direct labour

If sales are 15% above the breakeven volume, determine the net profit.
End of Topic