CHAPTER –one

Cost-Volume-Profit Analysis
• Cost-volume profit (CVP) analysis examines the
behavior of total revenues, total cost and operating
income as changes occur in the output level, selling
price, variable costs per unit or fixed costs.

• Managers often classify costs as fixed or variable when

making decisions that affect the volume of output.

• And want to know how such decision will affect costs

and revenues.

• Yet, a useful starting point in their decision process is to

specify the relationship between the volume of out puts
and costs and revenues.
• The mangers of profit-seeking organizations usually
study the effects of output volume on revenue (sales),
expenses (costs) and net income (net profit).
• This study is commonly called cost-volume-profit
(CVP) analysis.

• The mangers of non profit organizations also benefit

from the study of CVP relationships. Why?
• No organization has unlimited resources, and
• knowledge of how cost fluctuate as volume changes
helps managers to understand how to control costs.

• For example, administrators of nonprofit hospitals are

constantly concerned about the behavior of costs as the
volume of patients fluctuates.
• CVP analysis can be used to
develop predictions of what
can happen under alternative
strategies concerning sales
volume, selling price, variable
costs or fixed costs.
Cost-Volume Profit Assumptions
Cost-Volume- Profit (CVP) analysis is based on
several assumptions.
1.Changes in the level of revenues and costs
arise only because of changes in the number of
units of product (service) produced and sold
2.Total costs can be divided into a fixed and
variable component with respect to the level of
output.
3.The behavior of total cost and total revenue is
linear in relation to units of output within the
relevant range and time period.
4. The unit selling price, unit variable
costs, and fixed costs are known and
constant.
5.The analysis either cover a single product
or assumes that the sales mix when
multiple products are sold.
6.Time value of money is not considered.
• A cost behavior is described in terms of
how its amount changes in relation to
production and sales volume changes.
 Total fixed costs remain constant to changes in
sales volume.
 Total variable costs change in direct
proportion to sales volume changes.
• Mixed costs display the effects of both
fixed and variable components.
• Step costs remains the same over various
ranges of the level of activity,
The Breakeven point and target profit
• The breakeven point is a circumstance where
total revenues equal to total cost- that is, where
the operating income is zero.

• Why would mangers be interested in the

breakeven point?
• Because mainly the manager want to avoid
operating losses.
• Breakeven point can be determined by using:
 The equation method,
 The contribution margin method and
 The graph method.
Abbreviations used in CVP
• USP= Unit selling price
• UVC= Unit variable costs
• UCM= Unit contribution margin (USP-UVC)
• CM % = Contribution margin percentage (UCM/USP)
• FC = Fixed costs
• Q = Quantity of out puts units sold (and manufactured)
• OI = Operating income
• TOI = Target operating income
• TNI = Target net income
 Example 1:
Petram Company manufactures and sells pens.
Currently, 5,000,000 units are sold per year at a selling
price of $ 0.50 per unit. Fixed costs are $ 900,000 per
year. Variable costs are $ 0.30 per unit.
A. Equation method
Revenues –Variable cost- Fixed cost = Operating income

(USP x Q) – (UVC x Q) – Fixed = 0

0.5 Q – 0.3 Q – 900,000 – 0
0.2Q 900,000

0.2 0.2
Q  4,500,000
If petram sells fewer than 4,500,000 units, it
will have a loss, if it sells 4,500,000 it will
break even; and if it sells more that 4,500,000 it
will make a profit.

The break even can be expressed in revenue

(birr)
=4,500,000 X $0.5 selling price = $2,250,000
C) Graph method
• Plot a line of total costs and a line of
total revenues.
• Their point of intersection is
breakeven point.
• The graph also shows the profit or
loss outlook for a wide range of
output levels beside the breakeven
point.
 Target Net income and Income taxes
• Thus far, we have ignored the effect of income
taxes in our CVP analysis.
• At times, managers want to know the effect of their
decisions on income after taxes.
• Net income is operating income minus income
taxes.
• CVP calculations for target income must then be
stated in terms of target net income instead of target
operating income.

• Revenues – Variable cost- Fixed cost = Target operating income

Cost planning and CVP
• CVP- based sensitivity analysis highlights the
risks and returns that an existing cost structure
holds for an organization.
• This will help managers to consider and evaluate
alternative cost structures.

• The risk return tradeoff across alternative cost

structures is usefully summarized in a measure
called operating leverage.

• Operating leverage describes the effects that

fixed costs have in contribution margin.
• Organizations with a high proportion of
fixed costs in their cost structures have
high operating leverage.
• As a result, small changes in sales lead to
large changes in operating incomes.
• Consequently, if sales increase, operating
incomes increase relatively more, yielding
higher returns.
• If sales decrease, however, operating
incomes decline relatively more, leading to
grater risk of losses.
• high fixed costs and low variable costs
structure is more risky because it provides the
highest possible net income or the highest
possible net loss.
• Net income (Net loss) is highly variable
depending on the actual level of sales.
• The degree of operating leverage (DOL)
equals contribution margin divided by
operating income indicates a percentage
change in operating income because of a
change in sales.