Cost Volume Profit Analysis

Cost-Volume-Profit (CVP) analysis is a managerial accounting technique that is concerned with the effect of sales volume and product costs on operating profit of a business. It deals with how operating profit is affected by changes in variable costs, fixed costs, selling price per unit and the sales mix of two or more different products. CVP analysis has following assumptions: 1. All cost can be categorized as variable or fixed. 2. Sales price per unit, variable cost per unit and total fixed cost are constant. 3. All units produced are sold. Where the problem involves mixed costs, they must be split into their fixed and variable component by High-Low Method, Scatter Plot Method or Regression Method.

CVP Analysis Formula

The basic formula used in CVP Analysis is derived from profit equation: px = vx + FC + Profit In the above formula, p is price per unit; v is variable cost per unit; x are total number of units produced and sold; and FC is total fixed cost Besides the above formula, CVP analysis also makes use of following concepts:

Contribution Margin (CM)

Contribution Margin (CM) is equal to the difference between total sales (S) and total variable cost or, in other words, it is the amount by which sales exceed total variable costs (VC). In order to make profit the contribution margin of a business must exceed its total fixed costs. In short: CM = S VC

Unit Contribution Margin (Unit CM)

Contribution Margin can also be calculated per unit which is called Unit Contribution Margin. It is the excess of sales price per unit (p) over variable cost per unit (v). Thus: Unit CM = p v

Contribution Margin Ratio (CM Ratio)

Contribution Margin Ratio is calculated by dividing contribution margin by total sales or unit CM by price per unit.

Break-even Point Equation Method

Break-even is the point of zero loss or profit. At break-even point, the revenues of the business are equal its total costs and its contribution margin equals its total fixed costs. Break-even point can be calculated by equation method, contribution method or graphical method. The equation method is based on the cost-volume-profit (CVP) formula: px = vx + FC + Profit Where, p is the price per unit, x is the number of units, v is variable cost per unit and FC is total fixed cost.

Calculation
BEP in Sales Units
At break-even point the profit is zero therefore the CVP formula is simplified to: px = vx + FC

Solving the above equation for x which equals break-even point in sales units, we get: Break-even Sales Units = x = FC pv

BEP in Sales Dollars

Break-even point in number of sales dollars is calculated using the following formula: Break-even Sales Dollars = Price per Unit Break-even Sales Units

Example
Calculate break-even point in sales units and sales dollars from following information: Price per Unit $15 Variable Cost per Unit $7 Total Fixed Cost $9,000 Solution We have, p = $15 v = $7, and FC = $9,000 Substituting the known values into the formula for breakeven point in sales units, we get: Breakeven Point in Sales Units (x) = 9,000 (15 7) = 9,000 8 = 1,125 units Break-even Point in Sales Dollars = $15 1,125 = $16,875

Break-even Point Contribution Margin Approach

The contribution margin approach to calculate the break-even point (i.e. the point of zero profit or loss) is based on the CVP analysis concepts known as contribution margin and contribution margin ratio. Contribution margin is the difference between sales and variable costs. When calculated for a single unit, it is called unit contribution margin. Contribution margin ratio is the ratio of contribution margin to sales. In this method simple formulas are derived from the CVP analysis equation by rearranging the equation and then replacing certain parts with Contribution Margin formulas.

Contribution Approach Formulas

BEP in Sales Units
We learned that, at break-even point, the CVP analysis equation is reduced to: px = vx + FC Where p is the price per unit, x is the number of units, v is variable cost per unit and FC is total fixed cost. Solving the above equation for x (i.e. Break-even sales units ): Break-even Sales Units = x = FC ( p v ) Since unit contribution margin (Unit CM) is equal to unit sale price (p) less unit variable cost (v), So, Unit CM = p v Therefore, Break-even Sales Units = x = FC Unit CM

BEP in Sales Dollars

Break-even point in dollars can be calculated via: Break-even Sales Dollars = Price per Unit Break-even Sales Units; or Break-even Sales Dollars = FC CM Ratio

Example

Calculate the break-even point in units and in sales dollars when sales price per unit is $35, variable cost per unit is $28 and total fixed cost is $7,000. Solution Contribution Margin per Unit = ( $35 $28 ) = $7 Break-even Point in Units = $7,000 $7 = 1,000 Break-even Point in Sales Dollars = 1,000 $35 or $7,000 20% = $35,000

Sales Mix Break-even Point Calculation

Sales mix is the proportion in which two or more products are sold. For the calculation of break-even point for sales mix, following assumptions are made in addition to those already made for CVP analysis: 1. The proportion of sales mix must be predetermined. 2. The sales mix must not change within the relevant time period. The calculation method for the break-even point of sales mix is based on the contribution approach method. Since we have multiple products in sales mix therefore it is most likely that we will be dealing with products with different contribution margin per unit and contribution margin ratios. This problem is overcome by calculating weighted average contribution margin per unit and contribution margin ratio. These are then used to calculate the break-even point for sales mix. The calculation procedure and the formulas are discussed via following example:

Example: Formulas and Calculation Procedure

Following information is related to sales mix of product A, B and C. Product A B C Sales Price per Unit $15 $21 $36 Variable Cost per Unit $9 $14 $19 Sales Mix Percentage 20% 20% 60% Total Fixed Cost $40,000 Calculate the break-even point in units and in dollars.

Calculation
Step 1: Calculate the contribution margin per unit for each product: Product A B C Sales Price per Unit $15 $21 $36 Variable Cost per Unit $9 $14 $19 Contribution Margin per Unit $6 $7 $17 Step 2: Calculate the weighted-average contribution margin per unit for the sales mix using the following formula: Product A CM per Unit Product A Sales Mix Percentage + Product B CM per Unit Product B Sales Mix Percentage + Product C CM per Unit Product C Sales Mix Percentage = Weighted Average Unit Contribution Margin Product A B C Sales Price per Unit $15 $21 $36 Variable Cost per Unit $9 $14 $19 Contribution Margin per Unit $6 $7 $17 Sales Mix Percentage 20% 20% 60% $1.2 $1.4 $10.2 Sum: Weighted Average CM per Unit $12.80 Step 3: Calculate total units of sales mix required to break-even using the formula: Break-even Point in Units of Sales Mix = Total Fixed Cost Weighted Average CM per Unit Total Fixed Cost $40,000

 Weighted Average CM per Unit $12.80 Break-even Point in Units of Sales Mix 3,125 Step 4: Calculate number units of product A, B and C at break-even point: Product A B C Sales Mix Ratio 20% 20% 60% Total Break-even Units 3,125 3,125 3,125 Product Units at Break-even Point 625 625 1,875 Step 5: Calculate Break-even Point in dollars as follows: Product A B C Product Units at Break-even Point 625 625 1,875 Price per Unit $15 $21 $36 Product Sales in Dollars $9,375 $13,125 $67,500 Sum: Break-even Point in Dollars $90,000

Contribution Margin
Contribution margin (CM) is the amount by which sales revenue exceeds variable costs. It can be calculated as contribution margin per unit as well as total contribution margin, using the following formulas: Unit CM = Unit Price Variable Cost per Unit Total CM = Total Sales Total Variable Costs Variable costs are those which vary in proportion to the level of production. Variable cost may be direct as well as indirect. Direct variable cost includes direct material cost and direct labor cost. Indirect variable costs include certain variable overheads. Total contribution margin can also be obtained by multiplying unit contribution margin by number of units sold. Similarly, contribution margin per unit can also be calculated by divided total contribution margin by number of units sold.

Contribution Margin Ratio

Contribution margin ratio is contribution margin as percentage of sales. It can be calculated as shown in the following formula: Unit Contribution Margin Total Contribution Margin CM Ratio = = Unit Price Total Sales Contribution margin and contribution margin ratio are used in the breakeven analysis.

Example
Use the following information contribution margin ratio: Price Per Unit $22 Units Sold 802 Total Variable Cost $9,624 Solution Total Sales Total Contribution Margin Contribution Margin Per Unit CM Ratio to calculate unit contribution margin, total contribution margin and

= = = =

802 $22 = $17,644 $17,644 $9,624 = $8,020 $8,020 802 = $10 $8,020 $17,644 = $10 $22 45%

Margin of Safety (MOS)

In break-even analysis, margin of safety is the extent by which actual or projected sales exceed the break-even sales. It may be calculated simply as the difference between actual or projected sales and the break-even sales. However, it is best to calculate margin of safety in the form of a ratio. Thus we have the following two formulas to calculate margin of safety: MOS = Budgeted Sales Break-even Sales Budgeted Sales Break-even Sales MOS = Budgeted Sales Margin of Safety can be expressed both in terms of sales units and currency units. The margin of safety is a measure of risk. It represents the amount of drop in sales which a company can tolerate. Higher the margin of safety, the more the company can withstand fluctuations in sales. A drop in sales greater than margin of safety will cause net loss for the period.

Example
Use the following information to calculate margin Sales Price per Unit $40 Variable Cost per Unit $32 Total Fixed Cost $7,000 Budgeted Sales $40,000 Solution Breakeven Sales Units = $7,000 ($40 - $32) Budgeted Sales Units = $40,000 $40 Margin of Safety = (1000 875) 1,000 of safety:

= 875 = 1,000 = 12.5%

Degree of Operating Leverage

Degree of operating leverage is the multiple by which operating income of a business changes in response to a given percentage change in sales. Degree of operating leverage is a measure of the extent of operating leverage i.e. the relationship between operating income and sales of a business. If operating income is more sensitive to changes in sales, the business is said to have high operating leverage and vice versa. Similarly, if operating profit margin is higher, the business is said to have high operating leverage and vice versa.

Formulas
Degree of operating leverage can be calculated using any of the following formulas: Degree of operating leverage = Degree of operating leverage = Degree of operating leverage = Degree of operating leverage = change in operating income changes in sales contribution margin operating income sales variable costs sales variable costs fixed costs contribution margin percentage operating margin

Example
Calculate degree of operating leverage in the following cases and predict the increase in operating income subject to 15% increase in sales. Company A: operating income increases by 15% if sales increase by 10%. Company B: sales are $2,000,000, contribution margin ratio is 40% and fixed costs are $400,000

Solution Company A: Degree of operating leverage = % change in operating income/% change in sales = 15%/10% = 1.5 In response to a 15% increase sales, operating income will increase by 22.5% [=1.5 15%] Company B: Operating margin = ($2,000,000 0.4 $400,000) $2,000,000 = 20% Degree of operating leverage = contribution margin percentage/operating margin = $40% 20% = 2% Increase in operating income in response to 15% increase in sales = 2 15% = 30%