COST-VOLUME-PROFIT (CVP) ANALYSIS

What is it?
It is a planning and decision-making tool.
CVP analysis examines the behavior of total revenues, total costs, and operating
income (profit) as changes occur in the output level, selling price, variable cost per
unit, and/or fixed costs of a product or service.
This week we look at CVP. Next week we look at decision-making and planning.
Assumptions of CVP analysis

Changes in the level of revenues and costs arise only because of changes in
the number of product (or service) units produced and sold (that is, the
number of output units is the only driver of revenues and costs).
Total costs can be separated into a fixed component that does not vary with
the output level and a component that is variable with respect to the output
level.
When represented graphically, the behaviors of both total revenues and total
costs are linear (straight lines) in relation to the output level within the
relevant range (and time period).
The analysis either covers a single product or assumes that the proportion of
different products when multiple products are sold will remain constant as the
level of total units sold changes.
All production, management, marketing policies remain unchanged during
the period.

CVP assumptions simplify real-world situations, many companies have found CVP
relationships can be helpful in making decisions about strategic and long-range
planning.
Application of CVP analysis in different industries
CVP analysis can be applied to service organizations and nonprofit organizations.
The key is measuring their output. Unlike manufacturing and merchandising
companies that measure their output in units of product, the measure of output
differs from one service industry (or nonprofit organization) to another. For example,
airlines measure output in passenger-miles and hotels/motels use room-nights
occupied. Government welfare agencies measure output in number of clients served
and universities use student credit-hours.
Profit equation as key concept

The key relation for CVP analysis is the profit equation. Every organizations
financial operations can be stated as a simple relation among total revenues (TR),
total costs ( TC ), and operating profit:
Operating profit = Total revenues Total costs
Profit = TR TC
Both total revenues and total costs are likely to be affected by changes in the
amount of output.
We rewrite the profit equation to explicitly include volume, allowing us to analyze
the relations among volume, costs, and profit. Total revenue (TR) equals average
selling price per unit (P) times the units of output (X):
Total revenue = Price x Units of output produced and sold
TR = PX
Total costs (TC) may be divided into a fixed component that does not vary with
changes in output levels and a variable component that does vary. The fixed
component is made up of total fixed costs (F) per period; the variable component is
the product of the average variable cost per unit (V) multiplied by the quantity of
output (X). Therefore, the cost function is:
Total costs = (Variable costs per unit x Units of output) + Fixed costs
TC = VX + F
Combining gives:
Profit = (Price Variable costs) x Units of output Fixed costs = (P V)X F
Note that an important distinction for decision making is whether costs are fixed or
variable. That is, for decision making, we are concerned about cost behavior, not
the financial accounting treatment, which classifies costs as either manufacturing or
administrative. Thus, V is the sum of variable manufacturing costs per unit and
variable marketing and administrative costs per unit; F is the sum of total fixed
manufacturing costs and fixed marketing and administrative costs for the period;
and X refers to the number of units produced and sold during the period.
Example
Price = $.60, variable cost per unit = $.36 (therefore, contribution margin per unit =
$.24), and fixed costs = $1,500. Production is 12,000 units.
Profit = (P V)X F = ($.60 $.36) x 12,000 $1,500 = $1,380

To simplify, we use the term Profit in the equation to mean the same thing as
Operating Profit on income statements.
Definition of cost
Cost is a resource sacrificed or foregone for the purpose of achieving a specific
objective.
However, it is not just any sacrifice or resource foregone, but beneficial sacrifice, i.e.
it is expected that greater future benefits will eventuate.

Classification of costs
Costs can be classified based on the following attributes:
By Nature
In this type, material, labor and overheads are three costs, which can be further
sub-divided into raw materials, consumables, packing materials, and spare parts
etc.
By Degree of Traceability of the Product
Direct and indirect expenses are main types of costs come under it. Direct
expenses may directly attributable to a particular product.
More specifically - Direct expenses can be defined as expenses which can be
accurately traced to a cost object with little effort. Cost object may be a product, a
department, a project, etc. Direct expenses typically benefit a single cost object
therefore the classification of any expense either as direct or indirect is done by
taking the cost object into perspective.
Indirect expense is expense which is incurred for the benefit of more than one cost
object or which cannot be easily or efficiently traced to a specific cost object.
A particular cost may be direct expense for one cost object but indirect expense for
another cost object.
Most direct costs are variable but this may not always be the case. For example, the
salary of a supervisor for a month who has only supervised the construction of a
single building is a direct fixed cost incurred on the building.
Example of shoe manufacturing - Leather in shoe manufacturing is a direct expense
and salaries, rent of building etc. come under indirect expenses.
Example of direct expenses in concrete production- Cost of gravel, sand, cement
and wages incurred on production of concrete. Example of indirect expenses in
3

concrete production - Cost of depreciation, insurance, power, salaries of supervisors

incurred in a concrete plant.
By Controllability
In this classification, two types of costs fall:
Controllable - These are controlled by management like material labour and direct
expenses.
Uncontrollable - They are not influenced by management or any group of people.
They include rent of a building, salaries, and other indirect expenses.
By Relationship with Accounting Period
Classifications are measured by the period of use and benefit. The capital
expenditure and revenue expenditure are classified under it. Revenue expenses
relate to current accounting period. Capital expenditures are the benefits beyond
accounting period. Fixed assets come under category of capital expenditure and
maintenance of assets comes under revenue expenditure category.
By Association with the Product
There are two categories under this classification:
Product cost - Product cost is identifiable in any product. It includes direct material,
direct labor and overheads. Up to sale, these products are shown and valued as
inventory and they form a part of balance sheet. Any profitability is reflected only
when these products are sold. The costs of these products are transferred to costs
of goods sold account.

Direct materials: Represents the cost of the materials that can be identified
directly with the product at reasonable cost. For example, cost of paper in
newspaper printing, cost of
Direct labor: Represents the cost of the labor time spent on that product, for
example cost of the time spent by a petroleum engineer on an oil rig, etc.
Overheads: Represents all production costs except those for direct labor and
direct materials, for example the cost of an accountant's time in an
organization, depreciation on equipment, electricity, fuel, etc.

Period base cost - Selling expenditure and administrative expenditure, both are
period based expenditures. For example, rent of a building, salaries to employees
are related to period only.
Profitability and costs depend on both, product cost and time/period cost.
By Functions

Under this category, the cost is divided by its function as follows:

Production Cost - It represents the total manufacturing or production cost.
Commercial cost - It includes operational expenses of the business and may be subdivided into administration cost and selling and distribution cost.
By Change in Activity or volume
Under this category, the cost is divided as fixed, variable, step and semi-variable
costs. (See discussion further)
By Relevance
Under this category, costs are divided into relevant and irrelevant.
In managerial accounting we describe costs that are specific to management's
decisions.

The concept of relevant costs eliminates unnecessary data that could

complicate the decision-making process.
Erroneously considering irrelevant costs can lead to unsound business
decisions.
Also, ignoring irrelevant data in analysis can save time and effort.

A relevant cost (also called avoidable cost or differential cost) is a cost that differs
between alternatives being considered. In order for a cost to be a relevant cost it
must be: future, cash flow and incremental.
Irrelevant costs are costs that are not affected by the ultimate decision. In other
words, these are the costs which shall be incurred in the all managerial alternatives
being considered. Since they are the same in all alternatives, they become
irrelevant and need not be considered in calculations made for managerial analysis.
If costs appear only under one alternative, they may still be called irrelevant, if they
fall into one of the three following categories:

Sunk costs. These are past costs.

Committed costs. These are non-incremental costs.
Notional or non-cash costs (e.g depreciation and amortization). These are
non-cash costs.

Classifying material, labor and overheads as direct or indirect expense

Classifying fixed and variable costs as direct and indirect

Prime and conversion costs

Prime costs are all the direct costs of a product i.e. those costs that can be traced
conveniently to each unit. These include direct materials cost and direct labor cost.
Conversion costs are all manufacturing costs other than direct materials cost. These
include direct labor costs and manufacturing overheads.
The greater the proportion of prime costs in total costs of a product, the more
reliable is the cost estimate of the product. Conversion costs are the costs that are
incurred in converting direct raw material into finished goods and hence the name.
Prime costs and conversion costs have direct labor cost as an overlapping item.

Prime costs = direct materials cost + direct labor cost

Conversion costs = direct labor cost + manufacturing overheads
Example
Elite Furniture is a small furniture manufacturer. In the first week of December, they
worked exclusively on an order to build 5 conference tables. Costs incurred are as
follows:

Opening stock of timber $50

Timber purchased during the week
2,000
Closing stock of timber
250
Glass purchased for table tops
500
Labor hours worked
100
Wages per hour
40
Design engineer salary allocated to the job 2,500
Indirect materials and utilities cost allocated to the job

Solution

3,000

Timber consumed = opening stock + purchases closing stock = $50 + $2,000

$250 = $1,800
Other direct materials used (glass) = $500
Total direct materials cost = $1,800 + $500 = $2,300
Direct manufacturing labor cost = hours worked * hourly wage = 100 * $40 =
$4,000
Manufacturing overheads = design engineer salary + indirect materials and utilities
= $2,500 + $3,000 = $5,500
Prime costs = direct materials cost + direct labor cost = $2,300 + $4,000 = $6,300
Conversion costs = direct labor cost + manufacturing overheads = $4,000 + $5,500
= $9,500
Sunk costs
A sunk cost is a cost that an entity has incurred, and which it can no longer recover
by any means.
The terms sunk cost and past cost can be used interchangeably. A committed
cost is also, in effect, a past cost to the extent that an irrevocable decision has been
made to incur that cost.
Sunk costs should not be considered when making the decision to continue
investing in an ongoing project, since you cannot recover the cost.
However, many managers continue investing in projects because of the sheer size
of the amounts already invested in the past. They do not want to "lose the
investment" by curtailing a project that is proving to not be profitable, so they
continue pouring more cash into it. Rationally, they should consider earlier
investments to be sunk costs, and therefore exclude them from consideration when
deciding whether to continue with further investments.
An accounting issue that encourages this adverse behavior is that capitalized costs
associated with a project must be written off to expense as soon as the decision is
made to cancel the project. When the amount to be written off is quite large, this
encourages managers to keep projects running.
Example of sunk costs

Marketing study. A company spends $50,000 on a marketing study to see if

its new widget succeeds in the marketplace. The study concludes that the
widget will not be profitable. At this point, the $50,000 is a sunk cost. The

company should not continue with further investments in the widget project,
despite the size of the earlier investment.
Research and development. A company invests $2,000,000 over several
years to develop a new device. Once created, the market is indifferent, and
buys no units. The $2,000,000 development cost is a sunk cost, and so
should not be considered in any decision to continue or terminate the
product.
Training. A company spends $20,000 to train its sales staff in the use of new
tablet computers, which they will use to take customer orders. The computers
prove to be unreliable, and the sales manager wants to discontinue their use.
The training is a sunk cost, and so should not be considered in any decision
regarding the computers.
Hiring bonus. A company pays a new recruit $10,000 to join the organization.
If the person proves to be unreliable, the $10,000 payment should be
considered a sunk cost when deciding whether the individual's employment
should be terminated.

Costs and income statement

Costs and volume of activity

Costs can also be broadly classified as:

Fixed Costs - that stay the same when the volume of activity changes
Variable Costs - that vary in accordance with the volume of activity

Both types of costs are often associated with an activity, hence the importance to
the decision-making process of understanding the quantity and impact of both.
Fixed costs

Fixed costs are likely to change as a result of inflation or general price increases
but not as a result of change in volume of activity.
Fixed costs are almost always time-based i.e. they vary with the length of time
concerned. E.g. costs of flying an airplane (1 month or 1 hour before flight).
Fixed costs do not stay unchanged irrespective of level of output. They often must
increase to allow higher output levels.

Relevant range of fixed costs

Relevant range represents the production bracket expressed in terms of units within
which fixed costs are indeed fixed.
Identification of relevant range is important because knowing the production level
at which costs will change is critical for cost accounting, budgeting and financial
planning.
For example, 125H is a motor bike manufacturer. It stores ready-to-sell motor bikes
in a rented warehouse which is designed to accommodate 50,000 units at one time.
The warehouse rent per annum is $200,000 regardless of the number of bikes
parked there; hence, it is a fixed cost.

10

During the financial year 2015, sales dropped despite sustained production which
resulted in increase in number of motorbikes to be parked in the warehouse. Ending
inventory as at 31 March 2015 climbed to 60,000 bikes. 125H was forced to rent out
another warehouse that could accommodate 25,000 units at time for $120,000 per
annum.
The increased warehouse rent will remain fixed till the maximum capacity of that
second warehouse is reached i.e. inventory balance exceeds 75,000 motorbikes.
The relevant range is shown below:

Step cost as specific case of fixed costs

Step costs are also knows as semi-fixed costs. Very often confused with semivariable costs.
A step cost is a cost that does not change steadily with changes in activity volume,
but rather at discrete points.
A step cost is a fixed cost within certain boundaries, outside of which it will change.
When stated on a graph, step costs appear to be incurred in a stair step pattern,
with no change over a certain volume range, then a sudden increase, then no
change over the next (and higher) volume range, then another sudden increase,
and so on. The same pattern applies in reverse when the volume of activity
declines.
Fixed costs, such as building rent, should remain unchanged no matter how many
units are produced, though they can increase as the result of additional capacity
being needed (known as a step cost, where the cost suddenly steps up to a higher
level once a specific unit volume is reached).
When a step cost is incurred, the total fixed cost will now incorporate the new step
cost, which will increase the cost per unit. Depending on the size of the step cost
increase, a manager may want to leave capacity where it is and instead outsource

11

additional production, thereby avoiding the additional fixed cost. This is a prudent
choice when the need for increased capacity is not clear.
Step costing is extremely important to be aware of when a company is about to
reach a new and higher activity level where it must incur a large incremental step
cost. In some cases, incurring the extra amount of a step cost may eliminate profits
that management had been expecting with an increase in volume. If the increase in
volume is relatively minor, but still calls for incurring a step cost, it is possible that
profits will actually decline; a close examination of this issue may result in a
business turning away sales in order to maintain its profitability.
Conversely, a company should be aware of step costs when its activity level
declines, so that it can reduce costs in an appropriate manner to maintain
profitability. This may require an examination of the costs of terminating staff,
selling off equipment, or tearing down structures.
The point at which a step cost will be incurred can be delayed by implementing
production efficiencies, which increase the number of units that can be produced
with the existing production configuration. Another option is to offer overtime to
employees, so that the company can produce more units without hiring additional
full-time staff.
Variable costs
Variable costs are costs that vary in line with the volume of activity.

The graph suggests that costs are linear, i.e. normally the same per unit of
production irrespective of the number of units produced.
In some cases the line is not straight as higher volumes of activity may introduce
increasing or diminishing returns to production factor, economies of scale etc., thus
changing the variable costs line as production increases.

12

Alternatively, variable costs per unit may increase if, for example, employees are
paid an accelerating bonus for achieving higher levels of output.
Example of non-linear variable costs

Mixed (semi-variable) costs

These costs exhibit aspects of both fixed and variable costs.
Part of such costs are fixed and will not change with level of activity while some
parts are variable and vary accordingly with changes in level of activity. Thus, some
base-level cost will be always be incurred, irrespective of volume, as well as an
additional cost that is based only on volume.
Semi-variable costs are an important consideration for companies when planning
output levels, because semi-variable costs may limit profitability at higher
production levels and erode a company's bottom line.
As the level of usage of a semi-variable cost item increases, the fixed component of
the cost will not change, while the variable component will increase. The formula for
this relationship is:
Y = a + bx

13

Y = Total cost
a = Total fixed cost
b = Variable cost per unit of activity
x = Number of units of activity
For example, if a company owns a production line, the total cost of that equipment
in a month is a semi-variable cost. The depreciation associated with the asset is a
fixed cost, since it does not vary from period to period, while the utilities expense
will vary depending upon the amount of time during which the production line is
operational. The fixed cost of the production line is $10,000 per month, while the
variable cost of utilities is $150 per hour. If the production line runs for 160 hours
per month, then the semi-variable cost calculation is:
$34,000 Total cost = $10,000 fixed cost + ($150/hour x 160 hours)
From the perspective of a company manager, it is generally safer to increase the
variable portion of a semi-variable cost and decrease the fixed portion. Doing so
lowers the revenue level at which a business can break even, which is useful if the
business suffers from highly variable sales levels.

Per unit fixed and variable costs

Fixed cost per unit decreases with increase in production.
Variable cost per unit are constant, if we assume that variable costs are linear.
Treatment of mixed costs
Since mixed cost figures are not useful in their raw form, therefore they are split
into their fixed and variable components by using cost behavior analysis techniques
such as High-Low Method, Scatter Diagram Method and Regression Analysis.
Examples of costs

14

Variable cost
A common example of variable cost is direct materials cost. For example, a mobile
phone manufacturing company purchases speakers from another company at a cost
of $2 per speaker. The speaker is a direct materials cost for mobile phone
manufacturing company. One speaker is used to complete a mobile phone. To
complete 50 mobile phones, the variable cost will be $2 x 50 = $100.
Other examples of variable cost include sales commission and shipping costs etc.
Fixed
A common example of fixed cost is rent. For example, if mobile phone
manufacturing company rents a building for its factory for $5,000 per month, it will
have to pay $5,000 for every month even no mobile phone is produced during the
month.
Semi-variable (mixed)

The rental charges of a machine might include $500 per month plus $5 per
hour of use. The $500 per month is a fixed cost and $5 per hour is a variable
cost.
Another example of mixed or semi-variable cost is electricity bill. The
electricity bill can be divided into two parts (1) line rent and (2) cost of units
consumed. The line rent is not affected by the consumption of electricity
whereas the cost of units consumed varies with the change in units
consumed.
The cost for heating and lighting would remain largely fixed irrespective of
production activity, but for powering of machinery, it would increase with the
production level.
Wages, for instance, are semi-variable costs which multiply by 1.5 beyond 40
hours worked in a given week (also called time-and-a-half).
A production line may require $10,000 of labor to staff it at a minimal level
per day, but once a certain production volume is exceeded, the production
staff must work overtime. Thus, the basic $10,000 daily cost will be incurred
at all volume levels, and is therefore the fixed element of the semi-variable
cost, while overtime varies with production volume, and so is the variable
element of the cost.
In a typical cellphone billing contract, a monthly flat rate is charged in
addition to overage charges based on excessive bandwidth usage.
A salespersons salary typically has a fixed component such as a salary and a
variable portion such as a commission.

Semi-fixed (stepped)

15

Examples of step costs are adding new production facility or production

equipment, adding a forklift, or adding a second or third shift.
For example if a delivery van can carry 100 cases of beer you need one van
(fixed cost from 0-100 cases) but if output rises to 110 cases you need two
vans (higher fixed cost from 101-200 cases).
Employee salaries are sometime like this fixed until you need to hire a new
person.
Rent expense for a production facility may be $2,000 per month. However, if
production doubled and an additional facility is rented, the new fixed rent
charge may be $3,500. This charge remains fixed even though the dollar
amount changed because the production volume was adjusted.
A facility cost will remain steady until additional floor space is constructed, at
which point the cost will increase to a new and higher level as the entity
incurs new costs to maintain the additional floor space, to heat and air
condition it, insure it, and so forth.
A company can produce 10,000 widgets during one eight-hour shift. If the
company receives additional customer orders for more widgets, then it must
add another shift, which requires the services of an additional shift
supervisor. Thus, the cost of the shift supervisor is a step cost that occurs
when the company reaches a production requirement of 10,001 widgets. This
new level of step cost will continue until yet another shift must be added, at
which point the company will incur another step cost for the shift supervisor
for the night shift.

Accounting treatment of costs

Generally accepted accounting principles (GAAP) do not require a distinction
between fixed and variables costs. These costs are not distinguished on a
companys financial statements. Therefore, a semi-variable cost may be classified
into any expense account such as utility or rent. A semi-variable cost and analysis of
its components is a managerial accounting function for internal use only.
Break-even point analysis
Technique is referred to by several names: break-even point, break-even analysis,
break-even formula, break-even point formula, break-even model, cost-volumeprofit (CVP) analysis, or expense-volume-profit (EVP) analysis. The latter two names
are appealing because the break-even technique can be adapted to determine the
sales needed to attain a specified amount of profits.
Break-even point analysis
The point at which total of fixed and variable costs of a business becomes equal to
its total revenue is known as break-even point (BEP). At this point, a business
neither earns any profit nor suffers any loss. Break-even point is therefore also
known as no-profit, no-loss point or zero profit point.
16

Example
Assume a company sells 2,000 units of its only product for $50 per unit, variable
cost is $20 per unit, and fixed costs are $60,000 per month. Given these conditions,
the company is operating at the breakeven point:
Revenues, 2,000 $50 = $100,000
Deduct:
Variable costs, 2,000 $20 = $40,000
Fixed costs $60,000
Operating income $0
Ways to express break-even point
The breakeven point can be expressed two ways:

2,000 units and

$100,000 of revenues.

Use of break-even point analysis

Calculation of break-even point is important for every business because it tells
business owners and managers how much sales are needed to cover all fixed as
well as variable expenses of the business or the sales volume after which the
business will start generating profit. The computation of sales volume required to
break-even is known as break-even analysis. The concept explained above can also
be presented as follows:
When there is a profit

Revenues > Variable cost + fixed cost

At break-even point

Revenues = Variable cost + fixed cost

When there is a loss

Revenues < Variable cost + fixed cost

Three methods to compute break-even point

Equation method
The application of equation method facilitates the computation of break-even point
both in units and in dollars. As we have already described that the sales are equal to
17

total variable and fixed expenses at break-even point, the equation can therefore be
written as follows:
Sp Q = Ve Q + Fe
Or
SpQ = VeQ + Fe
Where;
Sp = Sales price per unit.
Q = Number (quantity) of units to be manufactured and sold during the period.
Ve = Variable expenses to manufacture and sell a single unit of product.
Fe = Total fixed expenses for the period.
Notice that:

The left hand side of the equation represents the total sales in dollars and
The right hand side of the equation represents the total cost.

If the information about sales price per unit, variable expenses per unit and the total
fixed expenses is available, we can solve the equation for Q to find the number of
units to break-even.
The break-even point in units can then be multiplied by the sales price per unit to
calculate the break-even point in dollars.
Example
Suppose, for example, there is a manufacturing business that is involved in
manufacturing and selling a single product. The annual fixed expenses to run the
business are $15,000 and variable expenses are $7.50 per unit. The sale price of
your product is $15 per unit. The number of units to be sold to break even can be
easily calculated using equation method:
Sp Q = Ve Q + Fe
15Q = 7.5Q + 15,000
15Q = 7.5Q + 15,000
15Q 7.5Q = 15,000
7.5Q = 15,000
Q = 15,000/7.5
18

Q = 2,000 units
The break-even point in units is 2,000 units and the break-even point in dollars can
be computed as follows:
= (2,000 units) ($15) = $30,000
Contribution margin method
Under this method, the total fixed expenses are divided by contribution margin per
unit (the concept is discussed a bit further). Assume that contribution margin per
unit = $7.5. Also assume that contribution margin ratio is 0.5.
Then, break-even point = Total fixed expenses / Contribution margin per unit
= 15,000 / 7.5 = 2,000 units
or
= (2,000 units) ($15) = $30,000
A little variation of this method is to divide the total fixed expenses by the
contribution margin ratio (CM ratio). Doing so results in break-even point in dollars.
Then, break-even point = Total fixed expenses / Contribution margin ratio
= $15,000 / 0.5 = $30,000
Graphical explanation of break even point

The number of units has been presented on the X-axis (horizontally) whereas dollars
have been presented on Y-axis (vertically).
The straight line represents the total annual fixed expenses.

19

The blue line represents the total expenses. Notice that the line has a positive or
upward slope that indicates the effect of increasing variable expenses with the
increase in production.
The yellow line with positive or upward slope indicates that every unit sold
increases the total sales revenue.
The total revenue line and the total expenses line cross each other. The point at
which they cross each other is the break-even point. Notice that the total expenses
line is above the total revenue line before the point of intersection and below after
the point of intersection. It tells us that the business suffers a loss before the point
of intersection and makes a profit after this point.
The difference between the total expenses line and the total revenue line before the
point of intersection (BE point) is the loss area. Notice that this area reduces as the
number of units sold increases. It means every additional unit sold before the breakeven point reduces the loss.
The difference between the total expenses line and the total revenue line after the
point of intersection (BE point) is the profit area. Notice that this area increases as
the number of units sold increases. It means every additional unit sold after the
break-even point increases the profit of the business.
Note that in economics the shape of revenue and cost curves is different, nonlinear, something similar to graph below.

Non-linear CVP analysis is mostly used in economics because economics are based
on many economic principles such as law of diminishing returns, productivity, etc.
which are more realistic and applicable to long-term perspective.
However, economic (non-linear) based CVP comes up with:
(1) Difficult and unreliable to estimate input parameters;

20

(2) Calculation difficulty (use of complicated mathematics like calculus to solve a

non-linear equation);
(3) Impractical and unrealistic approach for short-term profit planning because
many variables remain unchanged in short-term.
Therefore linear CVP analysis becomes more realistic, more applicable and more
practicable for short-term analysis.
Profit-volume (PV) chart
It is a slight variation of the break-even chart.

PV chart plots profit or loss against the volume of activity.

The slope of the graph is equal to the contribution per unit, since each additional
unit sold decreases the loss, or increases the profit, by the sales revenue per unit
less the variable cost per unit.
At zero level of activity, there are no contributions, so there is a loss equal to the
amount of the fixed costs. As the level of activity increases, the amount of the loss
gradually decreases until the break-even point is reached. Beyond the break-even
point, profits increase as activity increases.
The advantage of PV chart is that instead of considering revenues and costs
separately, we can analyze the relation between profit and volume directly.
Break even point analysis complicating factors
Predicting a precise amount of sales or profits is nearly impossible due to:

Companys many products (with varying degrees of profitability),

The company's many customers (with varying demands for service), and
The interaction between price, promotion and the number of units sold.

These and other factors will complicate the break-even analysis.

Contribution margin
21

Contribution margin is equal to sales revenue less total variable expenses incurred
to earn that revenue.

For a manufacturing firm, total variable expenses include both manufacturing

and non-manufacturing variable expenses.
In a service firm it is equal to revenue from provision of services less all
variable expenses incurred to provide such services.

You can see in graph below that contribution margin is related to fixed costs (but they
are not same). It is called contribution because it contributes to meeting the fixed
costs and, if there is any excess, it also contributes to profit. (Fixed cost = Total Cost
Variable Cost) (Contribution = Sales Revenue Variable Cost)

Ways to express contribution margin

Contribution margin can be expressed three ways:

In total,
On a per unit basis, and
As a percentage of revenues.

Contribution margin in total

The equation/formula of contribution margin in total is:

Gross contribution margin = Sales revenue Variable manufacturing

expenses
Contribution margin = Sales revenue (Variable manufacturing expenses +
Variable selling and administrative expenses)

Contribution margin per unit

Contribution margin per unit is the difference between selling price and
variable cost per unit.
22

Contribution margin per unit is also equal to contribution margin divided by

the number of units sold.

Contribution margin percentage (contribution margin ratio)

Contribution margin percentage is contribution margin per unit divided by

selling price.

Example of contribution margin in total

Sales revenue = $10,000
Variable expenses:

Manufacturing = $4,000
Marketing and administrative = $1,000

Fixed expenses:

Manufacturing = $2,000
Marketing and administrative = $500

From the above date we can calculate contribution margin and net operating profit
as follows:
Contribution margin = $10,000 ($4,000 + 1,000) = $5,000
Net operating profit = $5,000 ($2,000 + $500) = $2,500
The use of equation to calculate contribution margin figure is just for explaining the
concept. For managerial use, a proper contribution margin income statement is
prepared to compute this figure.
Example of contribution margin income statement
Again assume a company sells 2,000 units of its only product for $50 per unit,
variable cost is $20 per unit, and fixed costs are $60,000 per month.
The appropriate format of the income statement will be:
Revenues, 2,000 $50
Variable costs, 2,000 $20
Contribution margin
Fixed costs
Operating income

$100,000
40,000
60,000
60,000
$ -0-

Thus, the income statement above is reformatted to show a key line item,
contribution margin.
Another example
23

Assume a company sells 2,000 units of its only product for $50 per unit, variable
cost is $20 per unit, and fixed costs are $60,000 per month.
Given these conditions, the company is operating at the breakeven point. See
previous section.
Total contribution margin is $60,000.
Contribution margin per unit is: $50 $20 = $30.
Or, contribution margin per unit is: $60,000 2,000 = $30.
Contribution margin percentage is $30 $50 = 60%. It is also equal to contribution
margin divided by revenues: $60,000 $100,000 = 60%.
This contribution margin percentage means that 60 cents in contribution margin is
gained for each $1 of revenues.
Another example
The total sales revenue of Black Stone Crushing Company was $150,000 for the last
year. The fixed and variable expenses data of the last year is given below:
Variable expenses:

Manufacturing
$60,000
Marketing and administrative

30,000

Manufacturing
10,000
Marketing and administrative

8,000

Fixed:

Required: Calculate contribution margin ratio and also express it in percentage

form.
Solution:
Contribution margin = $150,000 ($60,000 + $30,000)
$150,000 $90,000
= $60,000
Contribution margin ratio = $60,000/$150,000
= 0.4
Contribution margin percentage = ($60,000/$150,000) 100

24

= 40%
The contribution margin is 40% of net sales.
Use and implications of contribution margin
The amount of contribution margin should be sufficient to cover all fixed costs as
well as to contribute towards profit. If the amount of contribution margin is not
enough to cover all fixed costs, the business will suffer a loss.
Contribution margin figure is even more important for multi-product companies. All
products are not equally profitable. High contribution margin products are more
profitable because they contribute more for covering fixed costs and providing for
profit. A multi-product company can increase its net operating profit by focusing its
attention to increase the sales of high contribution margin products.
Contribution margin and gross profit margin
Contribution margin contrasts with gross margin.
Gross margin is an important line item in the GAAP income statements of
merchandising and manufacturing companies. Gross margin is total revenues minus
cost of goods sold, whereas contribution margin is total revenues minus total
variable costs (from the entire value chain).
Gross margin and contribution margin will be different amounts (except in the highly
unlikely case that cost of goods sold and variable costs are equal).
Summary of break-even point and contribution margin

To confirm look at the formulas:

Break-even point = Fixed expenses/Contribution margin per unit; and
Contribution margin = Revenues Variable expenses, or Selling price variable
expense per unit
Margin of safety
25

Margin of safety (MOS) is the difference between actual sales and break even sales.
In other words, all sales revenue above the break-even point represents the margin
of safety. For example, if actual sales for the month of December 2015 are
$2,500,000 and the break-even sales are $1,500,000, the difference of $1,000,000
is margin of safety.
Margin of safety is an important figure for any business because it tells
management how much reduction in revenue will result in break-even. A higher
MOS reduces the risk of business losses. Generally, the higher the margin of safety,
the better it is.
The formula or equation of MOS is given below:
MOS = Actual or budgeted sales Sales required to break-even
Margin of safety is also expressed in the form of ratio or percentage that is
calculated by using the following formulas:
MOS ratio = MOS/Actual or budgeted sales
MOS percentage = (MOS/Actual or budgeted sales) 100
Graphically, MOS is shown on horizontal axis on the break-even chart:

Example
The break-even point of Best Inc. is $65,000 for the first quarter of the year 2016. If
margin of safety is $45,000, calculate the actual sales for the first quarter.
Solution:
Margin of safety = Actual sales Break-even sales
$45,000 = Actual sales $65,000

26

Actual sales = $45,000 + $45,000

Actual sales = $90,000
Break even analysis with multiple products
The procedure of computing break-even point of a multi-product company is a little
more complicated than that of a single product company.
A multi-product company can compute its break-even point using the following
formula:
BEP = Total fixed expenses/(Weighted average selling price Weighted average
selling expenses)
For computing break-even point of a company with two or more products, we must
know the sales percentage of individual products in the total sales mix. This
information is used in computing weighted average selling price and weighted
average variable expenses.
In the above formula, the weighted average selling price is worked out as follows:
(Sale price of product A Sales percentage of product A) + (Sale price of product B
Sale percentage of product B) + (Sale price of product C Sales percentage of
product C) + .
and the weighted average variable expenses are worked out as follows:
(Variable expenses of product A Sales percentage of product A) + (Variable
expenses of product B Variable expenses of product B) + (Variable expenses of
product C Sales percentage of product C) + .
When weighted average variable expenses per unit are subtracted from the
weighted average selling price per unit, we get weighted average contribution
margin per unit. Therefore, the above formula can also be written as follows:
BEP = Total fixed expenses/Weighted average contribution margin per unit
Target operating income
While the breakeven point is often of interest to managers, CVP analysis considers a
broader question: What amount of sales in units or in revenues is needed to achieve
a specified target operating income? The answer is easily obtained by adding target
operating income to total fixed costs in the numerator of the break-even point
formula.
Example

27

Assume a company sells 2,000 units of its only product for $50 per unit, variable
cost is $20 per unit, and fixed costs are $60,000 per month. Assume also target
operating income (TOI) is $15,000.
Unit sales to achieve TOI = ($60,000 + $15,000)/$30 = 2,500 units
Revenues to achieve TOI = ($60,000 + $15,000)/0.60 = $125,000
Taxation effects in CVP analysis
Because for-profit organizations are subject to income taxes, their CVP analyses
must include this factor.
The income-tax factor does not change the break-even point because no income
taxes arise if operating income is $0.
In many situations, the objective of planning will require earning some after-tax
profit amount. At the same time, CVP analysis requires before-tax profits for
calculation. Why? Because there exists no linear relationship between sales and
after-tax profit as taxes are charged on before-tax profit.
Income taxes may be incorporated into the basic model as follows:
After-tax profit = [(P - V )X - F ] x (1 - t ), where t is the tax rate.
Rearranging, we can find the target volume as follows:
Target volume (units) = {Fixed costs + [Target profit / (1 - t)]}/Unit contribution
margin
Notice that taxes affect the analysis by changing the target profit. That is, to
determine the volume required to earn a target after-tax income, you first
determine the required before-tax operating income (= target after-tax income / [1 tax rate]) and then solve for the target volume using the required before-tax income
as before.
Example
Suppose that the owner of the firm wants to find the number of prints required to
generate after-tax operating profits of $1,800. Suppose that P = $0.60, V = $.36,
the contribution margin per unit = $0.24, and F = $1,500. We assume the tax rate t
= 0.25; that is, U-Develop has a 25 percent tax rate.
To find the target volume, first determine the required before-tax income, which is
$2,400 (= $1,800 /
[1 - 0.25]).
Now, we can use the formula to determine the volume required to earn a target
profit of $2,400:
28

Target volume (units) = ($1,500 + $2,400)/$0.24 = 16,250 units

Uncertainty and sensitivity analysis
Single-number best estimates of input data for CVP analysis are subject to varying
degrees of uncertainty, the possibility that an actual amount will deviate from an
expected amount.

One approach to deal with uncertainty is to use sensitivity analysis.

Another approach is to compute expected values using probability
distributions.

Sensitivity analysis is a what if technique that managers use to examine how an

outcome will change if the original predicted data are not achieved or if an
underlying assumption changes. In the context of CVP analysis, sensitivity analysis
examines how operating income (or the breakeven point) changes if the predicted
data for selling price, variable cost per unit, fixed costs, or units sold are not
achieved. The sensitivity to various possible outcomes broadens managers
perspectives as to what might actually occur before they make cost commitments.
Use of Excel is common for sensitivity analysis.
Cost structures, risks and operating leverage
CVP-based sensitivity analysis highlights the risks and returns that an existing cost
structure holds for a company. This insight may lead managers to consider
alternative cost structures.
For example, compensating a salesperson on the basis of a sales commission (a
variable cost) rather than a salary (a fixed cost) decreases the companys downside
risk if demand is low but decreases its return if demand is high.

The risk-return tradeoff across alternative cost structures can be measured as

operating leverage.
Operating leverage describes the effects that fixed costs have on changes in
operating income as changes occur in units sold and hence in contribution
margin.
Companies with a high proportion of fixed costs in their cost structures have
high operating leverage. Consequently, small changes in units sold cause
large changes in operating income.

At any given level of sales:

Degree of operating leverage = Contribution margin/Operating income
Knowing the degree of operating leverage at a given level of sales helps managers
calculate the effect of changes in sales on operating income.
29

Cost structures differ widely among industries. Electric utilities and aircraft
manufacturers have a large investment in equipment, which results in a cost
structure with high fixed costs. In contrast, grocery retailers have a cost structure
with a higher proportion of variable costs. The utility is capital intensive; the grocery
store is labor intensive.
Cost structures also differ among firms within an industry. The airline industry in the
United States, for example, consists of so-called legacy carriers, such as American
Airlines and Continental Airlines, which have high fixed labor, pension, and other
costs and which operate using a hub and spoke system. Newer carriers, such as
Southwest Airlines and Jet Blue Airlines, have lower labor costs and operate out of
lower cost and less-congested airports. Therefore, the operating leverage of
American Airlines is higher than that of Jet Blue.
Example
We demonstrate the primary differences between two companies, Lo-Lev Company
(with relatively high variable costs) and Hi-Lev Company (with relatively high fixed
costs).

Note that although these firms have the same sales revenue and operating
profit, they have different cost structures.
Lo-Lev Companys cost structure is dominated by variable costs with a lower
contribution margin ratio of .25. Every dollar of sales contributes $.25 toward
fixed costs and profit.
Hi-Lev Companys cost structure is dominated by fixed costs with a higher
contribution margin of .75. Every dollar of sales contributes $.75 toward fixed
costs and profit.
Suppose that both companies experience a 10 percent increase in sales. LoLev Companys profit increases by $25,000 ($.25 x $100,000), and Hi-Lev
Companys profit increases by $75,000 ($.75 x$100,000). Of course, if sales
decline, the fall in Hi-Levs profits is much greater than the fall in Lo-Levs
profits.

30

In general, companies with lower fixed costs have the ability to be more
flexible to changes in market demands than do companies with higher fixed
costs and are better able to survive tough times.

Sales mix
Sales mix is the quantities of various products (or services) that constitute total unit
sales of a company. If the sales mix changes and the overall unit sales target is still
achieved, however, the effect on the breakeven point and operating income
depends on how the original proportions of lower or higher contribution margin
products have shifted. Other things being equal, for any given total quantity of units
sold, the breakeven point decreases and operating income increases if the sales mix
shifts toward products with higher contribution margins.
In multiple product situations, CVP analysis assumes a given sales mix of products
remains constant as the level of total units sold changes. In this case, the breakeven
point is some number of units of each product, depending on the sales mix.
Example
Assume a company sells two products, A and B. The sales mix is 4 units of A and 3
units of B. The contribution margins per unit are $80 for A and $40 for B. Fixed costs
are $308,000 per month. To compute the breakeven point:
Let 4X = Number of units of A to break even
Let 3X = Number of units of B to break even
BEP in X units = $308,000/[4 x $80 + 3 x $40] = $308,000/$440 = 700 units
A units to break even = 4 x 700 = 2,800 units
B units to break even = 3 x 700 = 2,100 units
Proof of break-even point:
A: 2,800 $80
B: 2,100 $40
Total contribution margin
Fixed costs
Operating income

$224,000
84,000
308,000
308,000
$ -0-

Expected costs versus historic costs

Frequently the calculations need to be based on expected costs rather than historic
costs. Thus, instead of using cost information for previous accounting periods we
use expected cost figures for the period in which decisions will be made.

31

Note that costs and selling prices do not have to move in tandem. E.g. there may be
periods, when selling prices cannot be increased (e.g. due to competitive
pressures), but costs increase. In this case, profits drop, and the break-even point
increases.

32