Lecture 5

Cost-Volume-Profit Analysis

CVP relation
CVP analysis is the study of effect of output volume on
revenue (sales), expenses (costs), and net income (net profit).
Let P and V be the price and variable cost per unit respectively.
Let N be the number of units sold and F be the fixed costs.
Profit before taxes = N P (F+NV) = N (P-V) F
Realize that P-V is the UCM (Discussed before)
Profit before taxes = N UCM F.
Define Contribution Margin Ratio (CMR) as (P-V)/P.
Profit equation can also be written following CMR approach.
N (P-V) is the same as (N P) (P-V)/P. Notice that (N P)
is the revenue and (P-V)/P is CMR. So, the profit equation can
also be written as
Profit = Revenue CMR - F
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Breakeven volume
BEV is the volume of sales at which profit equals
zero (alternatively, it is the volume at which all costs
equal revenues).
F
0 = NBEV (P-V) F NBEV = P V
BEV can also be expressed in sales dollars(S BEV)
F
F
F
P=
V
SBEV = NBEV P = P V P
=
CMR
P

where CMR is the contribution margin ratio.

We could have derived SBEV from the profit function
that we had developed using CMR approach.
0 = Breakeven revenue CMR F SBEV = F/CMR
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Bed-and-breakfast inn

Assume that you are starting a bed-and-breakfast inn. You are charging
$100 per person for a nights stay and full breakfast next morning. You are
outsourcing all essentials such as food, maid service for $70 per guest
per night. Your utility company has an agreement with you whereby you
pay the company $10 per guest per night. You have a manager with an
annual salary of $ 10,000 and the building is leased from the city at an
annual lease payment of $20,000.
Here P =$100; V = $80 F = $30,000
UCM = $20; CMR = 0.2
Let us characterize the breakeven volume for this firm!
Using UCM approach, breakeven volume in number of units as
$30,000/$20 = 1,500 guest nights. Alternatively, we can use the CMR
approach and calculate breakeven revenue as $30,000/0.2 = $150,000.

Cost-Volume-Profit Graph
Break-even sales point
1,500 guests or $150,000

$240000

Dollars

$210000
$180000

le
Sa

$150000
$100000

a
Tot

$50000

nu
e
rev

in e
l
e

e
n
i
l
st
o
c
l

Fixed cost line

0
0

12 15 18 21 24 27
6
9
Guest-nights (hundreds)
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Target Profit
Can use the profit equation to
determine the number of units to be
sold or revenue to be generated in
order to achieve a target profit (TP).
Number of units to be sold
=F TP
N TP
UCM

Sales dollars

requiredSTP=

F TP
CMR

CVP analysis and taxes

BEV is not affected by taxes. Why?
Volume required for target profit is
affected by taxes. Convert target
profit (which is after taxes) to
equivalent profit before taxes and
apply the same framework.
TPbefore taxes = TPafter taxes/(1-tax rate)

Using CVP model for pricing

What is the impact of reducing
selling prices on profit?
Reduction in UCM profits will decrease
Increase in sales volume profits will
increase

Total Contribution margin will be

maximized for a particular price.
Keep in mind the short term nature
of this analysis.
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Evaluate operating risk

using CVP
Margin of safety (MOS) is the excess
of expected (or current sales) over
the breakeven sales, expressed as a
percentage of expected (or current)
sales.
% change in profit before taxes = %
change in revenues (1/MOS)
Operating leverage is measured as
the ratio of fixed costs to total costs.
Higher the amount of fixed costs in the
cost structure, higher is the operating
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Multiproduct CVP analysis

Characterize an average product with CM =
weighted Unit Contribution Margin (WUCM).
WUCM = CM of individual products weighted by
the weights in the product mix.
Find the BEV in terms of the average product.
Express BEV in terms of individual products to be
sold in order to breakeven.
Same for volume required to earn TP.
Alternatively, we could have characterized the
average product with Weighted Contribution
Margin Ratio (WCMR).
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Key assumptions behind CVP model

and model limitations
Expenses can be classified into variable and
fixed categories.
The behavior of revenues and expenses is
linear over the relevant range
Expect no changes in efficiency and
productivity.
The difference in inventory level at the
beginning and at the end of a period is
insignificant.
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Key assumptions behind CVP model

and model limitations
Selling prices, unit variable costs and
fixed costs are known with certainty.
Assumption of single period
horizon.
Assumption of product mix to handle
multiple products.
Does not address whether the
existing product mix or capacity is
optimal.
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