CVP Analysis and Break Even Point

Posted: August 24, 2009 at 11:38 am | Tags: Break Even Point, CVP Analysis

I will utilize this fictional company as an example in each of the post below. My fictional company, Henry’s
Miracle Stomach Elixer Co, produces and sells stomach elixir next to the Saint Henry River in Escuintla,
Guatemala, a very popular tourist attraction. The bottles are sold to tourists at a stand adjacent to said river
at a price of $7 (American dollars). This water is rumored to cure travelers diarrhea, but only if it is blessed
by the local priest, Enrique, who has signed an exclusive contract with this company. Henry, the company’s
owner, produces a weekly balance sheet and income statement at the end of each week. We will utilize the
first week of June of 2009 which starts on a Monday.

On the last Friday in May Henry, the company’s owner, produces a balance sheet and income statement from
the week before. From this exercise Henry records some facts and numbers that will be useful for the next
week;

• Variable Costs
o Decorative Bottles used to store 8 fl ounces of Henry’s Miracle Stomach Elixir at a cost of $1 each
o Decorative String used to decorate the bottles at a cost of .05 each.
o Decorative sticky labels that are put on the bottle at a cost of .05 each
o Fine print legal disclaimer stickers bought from Henry’s brother, Heinz, the town lawyer at a cost of
.75 each.
o Bottles of American bottled water at a cost of .50 each purchased from the town import export
expert, Harry.
o Tablets of Loperamide (Imodium) to be dissolved in water at .25 each. Purchased from the town
doctor, Enrico.
o Fixed Costs
 $10 a week. Rent for souvenir stand spot in between the public water fountain and the very popular
Taco Grande stand.
 Raw Materials Beginning Inventory and Cost
 1000 decorative bottles
 1000 decorative strings
 1000 decorative sticky labels
 1000 fine print legal disclaimer stickers
 1000 bottles of American bottled water
 There is never work in process inventory.
 Henry buys new raw materials on the 15th of each month
 Direct Labor Costs
 Henrietta, Henry’s wife, assembles the bottles at .25 cents per bottle.
 Enrique, Henry’s son and also the town priest gets paid .25 cents per blessing of one bottle.
 Indirect Labor Costs
 Harriet , Henry’s daughter gets paid 10.00 a week salary to clean up the assembly work space
 Finished Goods Inventory
 100 bottles at a cost of $2.60 (direct materials and direct labor) each.
 The company’s salesman Heinrick gets paid a commission of .25 a bottle and no salary.
It was midnight on Friday and Henry could not sleep. After reviewing his favorite blogs he stumbled upon a
site that covered variable vs. fixed costs, cost-volume profit (CVP) relationships and break even analysis.
These concepts interested Henry because he was never sure what his profit would be until the end of the
week. Being the curious businessman he is, Henry decided to see how all of this relates to his Miracle
Stomach Elixir business. Henry was familiar with the concept of variable vs. fixed costs. His weekly
summary always broke down costs by variable vs. fixed. Variable costs are costs that vary, in total, in
proportion to the changes in levels of activity. All of Henry’s direct materials and direct labor costs were
variable costs. Fixed costs are costs that remain constant in total within the relevant range. Henry’s weekly
rent and daughter’s salary were fixed expenses. In order to get started in applying CVP Henry had to first
create a Contribution Margin Income Statement. The Contribution Margin Income Statement tells managers
what their contribution margin is. The contribution margin is the difference between total sales and total
variable expenses. This amount is used to cover fixed expenses and what is left over is net operating
income. Once you have the contribution margin you are able to calculate your breakeven point. The
breakeven point is the point at which profit is equal to 0. It is the point where the contribution margin
covers your fixed expenses. Below is Henry’s Contribution Margin Income statement:

Contribution Margin Income

Statement (1 Week) TOTAL PER UNIT
Sales (200 bottles at $7 per unit) $ 1,400.00 $ 7.00
Goods Available For Sale $ 1,055.00
(less)Ending Inventory $ (390.00)
Variable Cost of Goods Sold $ 665.00
Adjust Cost of Goods Sold (minus Harriet’s
fixed salary) $ (10.00)
Variable Selling and Admin Expenses
(Heinrick’s Commission) $ 50.00
$ 705.00 $ 3.53
Contribution Margin $ 695.00 $ 3.48
Fixed Expenses (Rent and Harriet’s
Salary) $ (20.00)
Net Operating Income $ 675.00

From here Henry can determine his breakeven point by using the following formula;

(Break Even Point in Units = Fixed expenses/Contribution margin)

(Breakeven point in Units sold=20/3.48=5.7 units (6 Units)

Henry must sell six units a week in order to break even. In order to determine Henry’s breakeven point in
total sales dollars Henry must first calculate the company’s contribution margin ratio using the following
formula;

(CM Ratio=Contribution margin/ total sales)

(CM Ratio = 695/1400=49.6%).
Henry can utilize the CM ratio to calculate the breakeven point in sales dollars by using the following
formula;

(Breakeven Point in Sales Dollars = Fixed expenses/CM Ratio)

(Breakeven point in sales dollars=20/49.6%=$40.32)

Henry must make 40.32 a week in order to break even.

At this point Henry can also play what if games like how many units he has to sell to profit $1000 a week or
what would happen if he wanted to rent an elixir bottle dispenser, at $25 a week, to be placed across town
next Montezuma’s Revenge Chili dogs.

In order to figure out how many units he has to sell in order to attain $1000 a week Henry must use the
following formula;

(Unit Sales to Attain Target Profit= Fixed Expenses + Target Profit/ Unit contribution margin)
(Unit Sales to attain target profit = (20+1000/3.48) =294 units

Henry must sell 294 units in order to make $1000 a week.

In order to calculate the Dollar sales to attain target profit Henry should use the following formula;

(Dollar Sales to attain target profit= Fixed Expenses + Target Profit/ CM Ratio)
(Dollar Sales to attain target profit = (20+1000/46.9%)=$2174.84

If Henry were to rent the elixir bottle dispenser at $25 a week he would need to increase the fixed expenses
variables in the calculations above by $25.

• (Break Even Point in Units with elixir dispensing machine = Fixed expenses/Contribution
margin)
(Breakeven point in Units sold with elixir dispensing machine =45/3.48=12.93 units (13
Units)
• (Breakeven Point in Sales Dollars = Fixed expenses/CM Ratio)
(Breakeven point in sales dollars=45/49.6%=$90.73)
• (Unit Sales to Attain Target Profit= Fixed Expenses + Target Profit/ Unit contribution
margin) (Unit Sales to attain target profit = (45+1000/3.48) =301 units
• (Dollar Sales to attain target profit= Fixed Expenses + Target Profit/ CM Ratio)
(Dollar Sales to attain target profit = (45+1000/46.9%)=$2228.15

Henry’s current weekly unit sales were 200 units. Henry predicts that the elixir dispensing machine would be
able to sell at least 120 more units. This would have him selling 320 units a week which would earn him
$66.12 (3.48 * 19) more than the target $1000 dollars a week. Henry decided to rent the elixir machine.

The above examples demonstrate the power of CVP analysis. Utilizing CVP analysis Henry was able to take
make informed decisions for his business