CHAPTER 10

COST-VOLUME-PROFIT ANALYSIS

1
COST-VOLUME-PROFIT ANALYSIS
 Cost volume profit analysis is a systematic method of
examining the relationship between selling price, total
sales revenue, volume of production, expenses and
profit.
 Among the factors which influence the level of profits,
the following are considered as key factors:
 Selling price

 Volume of sales

 Variable costs per unit

 Total fixed cost and

 Sales mix (the proportions or combination in which

different products are sold)

2
 Techniques of CVP analysis
1. Contribution Margin
2. Break-Even Analysis and
3. Profit-volume (p/v) Analysis

 In CVP analysis all expenses are classified

into fixed and variable expenses.
 Semi-variable expenses have to be divided
into their fixed and variable elements.

3
1. Contribution Margin Concept
 Contribution margin concept indicates the profit
potential of a business enterprise and also
highlights the relationship between cost, sales and
profit.
 Contribution margin is the excess of sales
revenue over variables costs
(under contribution concept variable cost includes all
variable production and selling costs)
Formula to calculate contribution margin ratio is

sales  var iable cos t

sales
4
Example:
 Assume the following information in case a company
sales $100,000
Variable costs 60,000
Fixed costs 30,000
A. How much is the contribution margin?
Contribution margin = sales – variable costs
= 100,000 – 60,000
= 40,000
Profit = contribution margin – Fixed cost
= 40,000 – 30,000
= 10,000
5
 B. Contribution margin ratio

Contribution margin ratio =

sales  var iable cos t
sales

100,000  60,000
100,000

= 40%

6
 Contribution margin ratio helps to know the effect of a
firm due to an increase or decrease in volume of
sales.
 For example, taking the previous example and if the
enterprise has an interest to increase its sales by
$40,000, what will be the profit?
Sales (100, 000 + 40,000) $140,000
Less: Variable cost (140, 000 x 60%) 84,000
Contribution margin (140, 000 x 40%) 56,000
Less: Fixed cost 30,000
Profit 26,000
7
2. Computing Break-Even Point

 The break-even point (expressed in units of

product or dollars of sales) is the unique
sales level at which a company neither earns
a profit nor incurs a loss.

8
Computing Break-Even Point

Total Unit
Sales Revenue (2,000 units) $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Operating income $ 10,000

Contribution margin is amount by which revenue

exceeds the variable costs of producing the revenue.

9
Computing Break-Even Point
Total Unit
Sales Revenue (2,000 units) $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Operating income $ 10,000

How much contribution margin must this company

have to cover its fixed costs (break even)?

10
Computing Break-Even Point
Total Unit
Sales Revenue (2,000 units) $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Operating income $ 10,000

How much contribution margin must this company

have to cover its fixed costs (break even)?
Answer: $30,000
11
Computing Break-Even Point
Total Unit
Sales Revenue (2,000 units) $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Operating income $ 10,000

How many units must this company sell to cover its

fixed costs (break even)?

12
Computing Break-Even Point
Total Unit
Sales Revenue (2,000 units) $ 100,000 $ 50
Less: Variable costs 60,000 30
Contribution margin $ 40,000 $ 20
Less: Fixed costs 30,000
Operating income $ 10,000

How many units must this company sell to cover its

fixed costs (break even)?
Answer: $30,000 ÷ $20 per unit = 1,500 units
13
 Formula for Computing Break-Even
Sales (in Units)
Finding the Break-Even Point
We have just seen one of the basic CVP
relationships – the break-even computation.
Fixed costs
Break-even point in units =
Contribution margin per unit

Unit sales price less unit variable cost

($20 in previous example)

14
Formula for Computing
Break-Even Sales (in Dollars)
The break-even formula may also be
expressed in sales dollars.

Fixed costs
Break-even point in dollars =
Contribution margin ratio

Unit sales price - unit variable cost

Unit sales price

15
Computing Break-Even Sales
Question 1
ABC Co. sells product XYZ at $5.00 per unit. If fixed
costs are $200,000 and variable costs are $3.00 per
unit, how many units must be sold to break even?

a. 100,000 units
b. 40,000 units
c. 200,000 units
d. 66,667 units

16
Computing Break-Even Sales
Question 1
ABC Co. sells product XYZ at $5.00 per unit. If fixed
costs are $200,000 and variable costs are $3.00 per
unit, how many units must be sold to break even?

a. 100,000 units
b. 40,000 units
c. 200,000 units
Unit contribution = $5.00 - $3.00 = $2.00
d. 66,667 units
Fixed costs $200,000
Unit contribution = $2.00 per unit
= 100,000 units
17
Computing Break-Even Sales
Question 2
Use the contribution margin ratio formula to
determine the amount of sales revenue ABC must
have to break even. All information remains
unchanged: fixed costs are $200,000; unit sales
price is $5.00; and unit variable cost is $3.00.

a. $200,000
b. $300,000
c. $400,000
d. $500,000
18
Computing Break-Even Sales
Question 2
Use the contribution margin ratio formula to
determine the amount of sales revenue ABC must
have to break even. All information remains
unchanged: fixed costs are $200,000; unit sales
price is $5.00; and unit variable cost is $3.00.
Unit contribution = $5.00 - $3.00 = $2.00
a. $200,000
Contribution margin ratio = $2.00 ÷ $5.00 = .40
b. $300,000
Break-even revenue = $200,000 ÷ .4 = $500,000
c. $400,000
d. $500,000
19
Computing Sales Needed to Achieve
Target Operating Income
Break-even formulas may be adjusted to show
the sales volume needed to earn
any amount of operating income.

Fixed costs + Target income

Unit sales =
Contribution margin per unit

Fixed costs + Target income

Dollar sales =
Contribution margin ratio
20
Computing Sales Needed to Achieve
Target Operating Income
• ABC Co. sells product XYZ at $5.00 per unit.
If fixed costs are $200,000 and variable costs
are $3.00 per unit, how many units must be
sold to earn operating income of $40,000?

a. 100,000 units
b. 120,000 units
c. 80,000 units
d. 200,000 units
21
Computing Sales Needed to Achieve
Target Operating Income
ABC Co. sells product XYZ at $5.00 per unit. If
fixed costs are $200,000 and variable costs
are $3.00 per unit, how many units must be
sold to earn operating income of $40,000?

Unit contribution = $5.00 - $3.00 = $2.00

a. 100,000 units
Fixed costs + Target income
b. 120,000 units Unit contribution
c. 80,000 units$200,000 + $40,000
= 120,000 units
d. 200,000 units $2.00 per unit
22
 What is Margin of Safety?
 Margin of safety (MOS) is the excess of
budgeted or actual sales over the break even
volume of sales.
 It stats the amount by which sales can drop
before losses begin to be incurred.
 The higher the margin of safety, the lower the
risk of not breaking even.

Margin of safety = Actual sales - Break-even sales

23
 Margin of safety provides a quick means of
estimating operating income at any level of
sales:
Operating Margin Contribution
Income = of safety × margin ratio
Example 1
Sales(400 units @ $250) $100,000
Break even sales $87,500
Calculate margin of safety

Calculation:
Sales(400units @$250) $100,000
Break even sales $ 87,500
---------
Margin of safety in dollars $ 12,500
=======

24
Example 2
 ABC’s contribution margin ratio is 40 percent.
If sales are $100,000 and break-even sales
are $80,000, what is operating income?

Operating Margin Contribution

Income = of safety × margin ratio

Operating
Income = $20,000 × .40 = $8,000

25
 What Change in Operating Income
Do We Anticipate?
 Once break-even is reached, every additional dollar of
contribution margin becomes operating income:

Change in Change in Contribution

operating income = sales volume × margin ratio

 ABC expects sales to increase by $15,000. How much

will operating income increase?

Change in
operating income = $15,000 × .40 = $6,000

26
Business Applications of CVP

Consider the following information developed by

the accountant at Cycle Co, a bicycle retailer:

Total Per Unit Percent

Sales (500 bikes) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000
Operating income $ 20,000

27
Business Applications of CVP

 Should Cycle Co spend $12,000 on advertising

to increase sales by 10 percent?

Total Per Unit Percent

Sales (500 bikes) $ 250,000 $ 500 100%
Less: variable expenses 150,000 300 60%
Contribution margin $ 100,000 $ 200 40%
Less: fixed expenses 80,000
Operating income $ 20,000

28
Business Applications of CVP

Should Cycle Co spend $12,000 on advertising

to increase sales by 10 percent?
500 550
550 × $500
Bikes Bikes
Sales $ 250,000 $ 275,000
Less: variable expenses 150,000 550 × $300 165,000
Contribution margin $ 100,000 $ 110,000
Less: fixed expenses 80,000 92,000
Operating income $ 20,000 $80000 + $12000$ 18,000

No, income is decreased.

29
Business Applications of CVP
Now, in combination with the advertising,
Cycle Co is considering a 10 percent price reduction that will
increase sales by 25 percent. What is the income effect?
500
Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin $ 100,000
Less: fixed expenses 80,000
Operating income $ 20,000

30
Business Applications of CVP
Now, in combination with the advertising,
Cycle Co is considering a 10 percent price reduction that will
increase sales by 25 percent. What is the income effect?
500 1.25 × 500 625
Bikes Bikes
Sales $ 250,000 625 × $450 $ 281,250
Less: variable expenses 150,000 187,500
Contribution margin $ 100,000 625 × $300 $ 93,750
Less: fixed expenses 80,000 92,000
Operating income $ 20,000$80000 + $12000 $ 1,750

Income is decreased even more.

31
 Business Applications of CVP
Now, in combination with advertising and a price cut, Cycle Co
will replace $20,000 in sales salaries with a $25 per bike
commission, increasing sales by 50 percent above the
original 500 bikes. What is the effect on income?
500
Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin $ 100,000
Less: fixed expenses 80,000
Operating income $ 20,000

32
 Business Applications of CVP
Now, in combination with advertising and a price cut, Cycle Co
will replace $20,000 in sales salaries with a $25 per bike
commission, increasing sales by 50 percent above the
original 500 bikes. What is the effect on income?
500 750
1.5 × 500
Bikes Bikes
Sales $ 250,000 750 × $450 $ 337,500
Less: variable expenses 150,000 243,750
Contribution margin $ 100,000 750 × $325 $ 93,750
Less: fixed expenses 80,000 72,000
Operating income $ 20,000 $92000 - $20000 $ 21,750

The combination of advertising, a price cut,

and change in compensation increases income.
33
CVP Analysis When a Company Sells
Many Products
Sales mix is the relative combination in which
a company’s different products are sold.
It refers to the ratio or relative combination of
each product’s sales to total sales.
Different products have different selling prices,
costs, and contribution margins.

34
 Sales mix is the composition of total sales broken
down among various products or product lines.
 Example: A company has three products labeled as
Model X, Model Y and Model Z. Sales on monthly
basis are expected to be as follows:
Model X Model Y Model Z Total

Unit 1,000 1,500 2,500 5,000

Sales ratio 20% 30% 50% 100%
 This means that for every 2 units of model x that are sold,
there are 3 units of model y and 5 units of model z. Or
 Multi products would have 2 units model x, 3 units model y
and 5 units model z, for a total of 10 units

35
Example:
 A company has three sales ratio of 2:3:5 for model x,
model y and model z. Total fixed costs for the month are
$200,000. The sales price, variable costs and
contribution margin associated with each product are as
follows:

Model X Model Y Model Z

 Sales prices $50 $25 $10
 Variable costs 30 15 8
 Contribution margin 20 10 2

How much is the total contribution margin of the average market basket
(consists of 10 units) based on the sales ratio?

36
Solution:

 The total contribution of the average market

basket is based on the sales ratio and
consists of 10 units
 = (2/10 x $20)*2 + (3/10 x $10)*3 + (5/10 x $2)*5
 =$40 + $30 + $10
 = $80

37
How much is the break even point in the
market basket?
 The break even point in the market basket is
computed using the break even point formula:-

$200000

$80
 2,500units
In order to fill 2,500 baskets, it will take the following amounts for each model:
Model x 500 units which is 2500 units X 2/10
Model y 750 units 2500 units X 3/10
Model z 1,250 units 2500 units X 5/10
This is the break even point for each model as long as the sales mix stays at
2:3:5
38
How much is the Break even point in
3 x $25 = $75
sales? 3 x $15 = $45
5 x $10 = $50
 Calculate the contribution margin ratio 5 x $8 = $40
Solution:
Model X Model Y Model Z Total

Sales price 2 x $50 = $100 $100 $75 $50 $225

Variable cost 2 x $30 = $60 $60 $45 $40 $145
Contribution Margin $40 $30 $10 $80

Contribution margin ratio = ($80 ÷ 225) x 100

= 35.555%
Then, Break even point in sales = ($200,000 ÷ 35.555%)
= $562,500
39