CH 3

CHAPTER 3
Cost-Volume-Profit
(CVP)
Analysis
Cost-Volume-Profit Analysis
Cost-volume-profit (CVP) analysis examines
the effects of changes of costs and volume

on a companys profits.
CVP analysis illustrates the profits from
alternatives, hence guides managers
planning.
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.
3-2
Learning Objective 1
Understand the assumptions
underlying CVP analysis.
3-3
Cost-Volume-Profit Assumptions
and Terminology
1. Changes in the level of revenues and costs arise
only because of changes in the number of product
(or service) units produced and sold.
2. Total costs can be divided into a fixed component
and a component that is variable with respect to
the level of output.
3-4
and Terminology
3. When graphed, the behavior of total revenues
and total costs is linear (straight-line) in relation
to output units within the relevant range
(and time period).
4. The unit selling price, unit variable costs, and
fixed costs are known and constant.
3-5
and Terminology
5. The analysis either covers a single product or
assumes that the sales mix when multiple
products are sold will remain constant as the
level of total units sold changes.
6. All revenues and costs can be added and
compared without taking into account the time
value of money.
3-6
Basic Formulae
3-7
Contribution Income Statement

A contribution income statement is an
income statement with costs classified by
behavior, rather than character.
Variable costs are grouped and subtracted
from revenues.
Fixed costs are grouped and subtracted
from contribution margin.
3-8
CVP
CVP Income
Income Statement
Statement -- Example
Example
Vargo Video Company produces DVD players.
Relevant data for June 2008:
Unit selling price of DVD player
Unit variable costs
Total monthly fixed costs
Units sold
$500
$300
$200,000
1,600
3-9
LO 5: Indicate what contribution margin is and how it can be expressed.
Explain the features
of CVP analysis.
3-10
Essentials of Cost-Volume-Profit
(CVP) Analysis Example
Assume that the Mary can purchase software packages
for $120 from a computer software wholesaler with a
privilege of returning all unsold packages and receiving
a full $120 refund per package within one year.
The average selling price per package is $200 and total
fixed costs amount to $2,000.
3-11
Case1:How much revenue will the business receive if 5
units are sold?
5 $200 = $1,000
How much variable costs will the business incur?
5 $120 = $600
Operating income: $1,000 600 2,000 = ($1,600)
3-12
Case2:How much revenue will the business receive if
40 units are sold?
40 $200 = $8,000
How much variable costs will the business incur?
40 $120 = $4,800
Operating income: $8,000 4,800 2,000 = $1,200
3-13
Compare Case1 and Case2:
The only numbers that change from selling
different quantities are total revenues and total
variable costs.
Contribution margin: the difference between

total revenues and total variable costs.
Contribution margin per unit: the difference
between selling price and variable cost per unit.
(or, Total contribution margin divided by total
quantity)
3-14
Case 1:
Contribution margin=1,000 600=400
Contribution margin per unit=400 / 5=80
Case 2:
Contribution margin=8,0004,800 =3,200
Contribution margin per unit=3,200 /40 =80
3-15
Contribution margin percentage (contribution margin
ratio) is the contribution margin per unit divided by
the selling price (or, contribution margin divided by
revenues).
Case 1: 400/1,000=40%
Case 2: 3,200/8,000=40%
3-16
Contribution margin
= Contribution margin per unit Number of units sold
= Contribution margin percentage Revenues
If the business sells 50 packages,
revenues will be $10,000 and
contribution margin would equal 40% $10,000 = $4,000
3-17
Determine the breakeven point
and output level needed to achieve
a target operating income using
the equation, contribution margin,
and graph methods.
3-18
Breakeven Point
Breakeven point (BEP): quantity of output
sold at which total revenues equal total costs,
i.e. operating income is $0.
Total revenues = Total costs
Sales
Variable
costs
Fixed
costs
3-19
Breakeven Analysis
Breakeven analysis: Process to find the breakeven point
Breakeven point can be expressed either in
sales units or in sales dollars
3-20
Abbreviations
SP = Selling price
VCU = Variable cost per unit
CMU = Contribution margin per unit
CMR = Contribution margin percentage
FC = Fixed costs
Q = Quantity of output units sold
(and manufactured)
3-21
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
or CMU=CM / Q
3-22
Contribution Margin
Contribution Margin also equals contribution
margin per unit multiplied by the number of

units sold
CM = CMU x Q
Contribution Margin Ratio (percentage)
equals contribution margin per unit divided by

selling price
CMR = CMU SP
or CMR=CM / S
3-23
Abbreviations
OI = Operating income
TOI = Target operating income
TNI = Target net income
3-24
Breakeven Analysis: Equation Method

SP Q VCU Q FC = OI
Let Q = number of units to be sold to break even
$200Q $120Q $2,000 = 0
$80Q = $2,000
Q = $2,000 $80 = 25 units
3-25
Breakeven Analysis: Contribution

Margin Method
A simple manipulation of the last equation,
and setting OI to zero will result in the

Breakeven Point (quantity):
BEQ = FC CMU
At this point, a firm has no profit or loss.
3-26

Margin Method
Sales VC FC = OI
(SP x Q) (VCU x Q) FC = OI
Q (SP VCU) FC = OI
Q (CMU) FC = OI
3-27

Margin Method
If per-unit values are not available, the
Breakeven Point may be restated in its

alternate format:
BE Sales = FC CMR (Breakeven point in
dollar)
The break-even point can be computed using
either contribution margin per unit (breakeven
units) or contribution margin ratio (breakeven
dollars).
3-28

Margin Method
$2,000 $80 = 25 units
$2,000 40% = $5,000
3-29
Breakeven Analysis: Graph Method

A CVP graph shows costs, volume and profits.
Used to visually find the break-even point
To construct a CVP graph:
1.Plot the total sales line starting at the zero

activity level
2.Plot the total fixed cost using a horizontal line
3.Plot the total cost line (starts at the fixed-cost
line at zero activity
4.Determine the break-even point from the
intersection of the total cost line and the
total sales line
3-30
Breakeven Analysis: Graph Method
Breakeven point = 25 units
Total
revenues
line
Operating
income
Operating
income area
Total
costs
line
Breakeven
point
= 25 units
Total
costs
line
Operating
loss area
Operating
loss area
Variable
costs
Fixed
costs
3-31
Review
Gossen Company is planning to sell 200,000 pliers
for $4 per unit. The contribution margin ratio is
25%. If Gossen will break even at this level of
sales, what are the fixed costs?
a. $100,000.
b. $160,000.
c. $200,000.
d. $300,000.
3-32
CVP Analysis: Profit Planning

Level of sales necessary to achieve a specified
income, This level can be expressed either in sales

units or in sales dollars.
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)
CMU
or S = (FC+OI)/CMR
3-33
CVP Analysis: Target Operating

Income
Assume that Mary wants to have an
operating income of $1,200.
How many packages must be sold?

($2,000 + $1,200) $80 = 40
What dollar sales are needed to achieve this income?
($2,000 + $1,200) 40% = $8,000

3-34
Understand how income
taxes affect CVP analysis.
3-35
CVP and Income Taxes

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 = I I
NI
I
(1-Tax Rate)
3-36
Target Net Income

and Income Taxes Example
Mary would like to earn
net income of $960.
The tax rate is 40%.
What is the target operating income?
Target operating income
= Target net income (1 tax rate)
TOI = $960 (1 0.40) = $1,600
3-37
Target Net Income

How many units must be sold?
Revenues Variable costs Fixed costs
= Target net income (1 tax rate)
$200Q $120Q $2,000 = $960 0.60
$80Q = $1,600 + $2,000
Q = $3,600 $80 = 45 packages
3-38
Target Net Income

Proof:
Revenues: 45 $200
Variable costs: 45 $120
Contribution margin
Fixed costs
Operating income
Income taxes: $1,600 40%
Net income
$9,000
5,400
$3,600
2,000
1,600
640
$ 960
3-39
Review
The mathematical equation for computing
required sales to obtain target net income is:
Required sales =
a. Variable costs + Target net income.
b. Variable costs + Fixed costs + Target net income.
c. Fixed costs + Target net income.
d. No correct answer is given.
3-40
Explain CVP analysis
in decision making and
how sensitivity analysis helps
managers cope with uncertainty.
3-41
Using CVP Analysis Example:

Advertising Decision
Suppose the Mary anticipates selling 40 packages.
Mary is considering an advertising campaign that
would cost $500.
It is anticipated that the advertising will increase
sales by 10% to 44 units.
Should the business advertise?
3-42

Advertising Decision
40 units sold with no advertising:
Contribution margin
Fixed costs
Operating income
$3,200
2,000
$ 1,200
44 units sold with advertising:

Contribution margin
Fixed costs
Operating income
$3,520
2,500
$ 1,020
3-43

Reducing Selling Price
Instead of advertising, Mary is considering
reducing the selling price to $175 per package.
It is anticipated that this will increase sales to 50
units, and at this quantity, the purchase price will
decrease to $115.
Should Mary decrease the selling price per
package to $175?
3-44

Reducing Selling Price
40 packages sold with no change in the selling price:
Operating income = $1,200

50 packages sold at a reduced selling price:
Contribution margin: (50 $60)
Fixed costs
Operating income
$3,000
2,000
$ 1,000
3-45
Sensitivity Analysis
A what-if technique that managers use to
examine how the outcome will change if the

original predicted data are not achieved or if
an underlying assumption changes.
What happens to profit if:
Selling price changes
Volume changes
Cost structure changes
Variable cost per unit changes

Fixed cost changes
3-46
Margin of Safety
Margin of safety: the amount by which budgeted
(actual) revenues exceed breakeven revenues.

An indicator of risk
what-if question: if budgeted revenues are above
breakeven and drop, how far can they fall below
budget before the breakeven point is reached.
The higher the margin of safety, the less likely it is to
suffer a loss.
Margin of safety percentage=
Margin of safety/ budgeted (actual) revenues
3-47
Sensitivity Analysis and

Uncertainty: Margin of Safety
Assume that Mary can sell 40 packages. Fixed
costs are $2,000
Contribution margin ratio is 40%.

Revenues at breakeven $2,000 .40 = $5,000.
Margin of safety= 40 200-5,000=3,000
Margin of safety percentage = 3,000/8,000=37.5%
3-48
Review
Marshall Company had actual sales of $600,000
when break-even sales were $420,000. What
is the margin of safety ratio?
a. 25%.
b. 30%.
c. 33 1/3%.
d. 45%.
3-49
Use CVP analysis to plan
fixed and variable costs.
3-50
Alternative Fixed/Variable Cost

Structures
CVP sensitivity analysis highlights the risks
and returns as fixed costs are substituted for
variable costs in cost structure.
3-51

Structures Example
Suppose that Mary has the following options:
Option 1: $2,000 fixed cost
Option 2: $800 fixed cost plus 15% of revenues
Option 3: 25% of revenues with no fixed cost
If 40 units are sold, no difference in operating income.
If 20 units are sold, option 1 leads to a loss.
If 60 units are sold, option 1 shows an operating
income of $2,800, greater than option 2 and 3.
3-52

Structures Example
Risks and returns among option 1 to 3:
Option1: highest risk and return.
Option3: lowest risk and return.
Implication to managers decision of cost structure:
Managers confidence in level of demand
Managers willingness to risk loss
3-53
Operating Leverage
Operating leverage describes the effects that
fixed costs have on changes in operating
income as changes occur in units sold.
Degree of operating leverage
= Contribution margin Operating income
Organizations with a high proportion of fixed
costs have high operating leverage.
3-54
Operating Leverage Example

What is the degree of operating leverage
at the sales of 40 units for the 3 options?
Option
1
2
3
Contribution margin
$3,200 $2,000 $1,200
Operating income
$ 1,200 $1,200 $1,200
Degree of operating leverage 2.67
1.67 1
3-55

What is the degree of operating leverage
at the sales of 60 units for the 3 options?
Option
1
2
3
Contribution margin
$4,800 $3,000 $1,800
Operating income
$ 2,800 $2,200 $1,800
Degree of operating leverage
1.71
1.36 1
3-56

Managers must monitor their operating leverage
carefully.
e.g. U.S. Airways, United Airlines
How to avoid the risk:
Fixed cost: a double-edged sword
3-57
Apply CVP analysis to a company
producing different products.
3-58
Effects of Sales-Mix on CVP

The formulae presented to this point have assumed a
single product is produced and sold

A more realistic scenario involves multiple products
sold, in different volumes, with different costs
For simplicitys sake, only two products will be
presented, but this could easily be extended to even
more products
Sales mix: the quantities of various products or
services that make up the total sales of a company.
3-59

Breakeven units
3-60

Break even revenues
3-61
Effects of Sales Mix on Income

Sales mix :
Sales price
Variable costs/unit
Contribution margin/unit
Contribution margin ratio
Units sold
Fixed cost
1
2
$200 $100
120
70
$80
$30
40% 30%
60
40
$4,500
3-62

What is the weighted-average budgeted
contribution margin per unit?
(80 60 + 30 40)/(60+40) =$60
What is the breakeven point?
$4,500/60=75 units
3-63

What is the breakeven in dollars?
Total CM:$80*60+$30*40=$6000
Total revenues: $200*60+$100*40=$16,000
Weighted-average CMR=37.5%
Breakeven revenues: $4,500/37.5%=$12,000
There is no unique breakeven point if sales mix
changes
3-64
Adapt CVP analysis to situations
in which a product has more
than one cost driver.
3-65
Multiple Cost Drivers

Variable costs may arise from multiple cost
drivers or activities. A separate variable cost

needs to be calculated for each driver.
3-66
Multiple Cost Drivers Example

Suppose that Mary will incur an additional
cost of $10 for preparing documents associated
with the sale of software to customers.
Assume that the business sells 40
packages to 15 different customers.
The cost structure depends on two cost drivers:
1. Number of units 2. Number of customers
3-67

What is the operating income from this sale?
Revenues: 40 $200
Variable costs:
Software: 40 $120
Documents: 15 $10
Total
Contribution margin
Fixed costs
Operating income
$8,000
4,800
150
4,950
3,050
2,000
$ 1,050
3-68

Assume 40 packages are sold to 40 different customers.
Revenues: 40 $200
Variable costs:
Software: 40 $120
Documents: 40 $10
Total
Contribution margin
Fixed costs
Operating income
$8,000
4,800
400
5,200
2,800
2,000
$ 800
3-69
Multiple Cost Drivers

There is no unique breakeven point when there
are multiple cost drivers.
3-70
Distinguish between
contribution margin
and gross margin.
3-71
Contribution Margin versus

Gross Margin
Contribution margin=Revenues All variable costs
Gross margin=Revenues Costs of goods sold
Contribution income statement emphasizes
contribution margin.
Financial accounting income statement
emphasizes gross margin.
3-72
Contribution Margin vs.

Gross Margin
Merchandising sector
3-73
Contribution Margin versus

Gross Margin
Manufacturing sector
3-74

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CHAPTER 3

the effects of changes of costs and volume

Contribution Income Statement

LO 5: Indicate what contribution margin is and how it can be expressed.

Contribution margin: the difference between

Contribution Margin per unit equals unit

selling price less variable cost per unit

margin per unit multiplied by the number of

Contribution Margin Ratio (percentage)

equals contribution margin per unit divided by

Breakeven Analysis: Equation Method

Breakeven Analysis: Contribution

and setting OI to zero will result in the

At this point, a firm has no profit or loss.

Breakeven Analysis: Contribution

Breakeven Analysis: Contribution

Breakeven Point may be restated in its

Breakeven Analysis: Contribution

Breakeven Analysis: Graph Method

1.Plot the total sales line starting at the zero

Breakeven Analysis: Graph Method

Breakeven point = 25 units

CVP Analysis: Profit Planning

income, This level can be expressed either in sales

CVP Analysis: Target Operating

How many packages must be sold?

($2,000 + $1,200) 40% = $8,000

CVP and Income Taxes

through this form:

Target Net Income

Target Net Income

Target Net Income

Using CVP Analysis Example:

Using CVP Analysis Example:

44 units sold with advertising:

Using CVP Analysis Example:

Using CVP Analysis Example:

Operating income = $1,200

examine how the outcome will change if the

Variable cost per unit changes

(actual) revenues exceed breakeven revenues.

Sensitivity Analysis and

Contribution margin ratio is 40%.

Alternative Fixed/Variable Cost

Alternative Fixed/Variable Cost

Alternative Fixed/Variable Cost

Operating Leverage Example

Operating Leverage Example

Operating Leverage Example

Effects of Sales-Mix on CVP

single product is produced and sold

Effects of Sales-Mix on CVP

Effects of Sales-Mix on CVP

Effects of Sales Mix on Income

Effects of Sales Mix on Income

Effects of Sales Mix on Income

Multiple Cost Drivers

drivers or activities. A separate variable cost

Multiple Cost Drivers Example

Multiple Cost Drivers Example

Multiple Cost Drivers Example

Multiple Cost Drivers