Cost-Volume-Profit Analysis

Dr. D. K. Nauriyal
Dept. of HSS
IIT Roorkee
Break-even analysis: Break-even point
John sells a product for $10 and it costs $5 to produce
(UVC) and has fixed cost (FC) of $25,000 per year.
How much will he need to sell to break-even? How
much will he need to sell to make $1000?

Company XYZ has to choose between two machines to
purchase. The selling price is $10 per unit. Machine A:
annual cost of $3000 with per unit cost (VC) of $5.
Machine B: annual cost of $8000 with per unit cost
(VC) of $2.
Determine break-even point for Machine A and
Machine B.
Suppose you were the owner of a water store. An
advertising agency offers to guarantee that using their ad
campaign would increase the volume of your business by
50 percent.
How could you decide if the ad campaign would be worth the
cost?

Or, suppose that you are the chairman of a group that is
considering beginning a school.
What kind of information would you need to figure out if the
school would be feasible?

In all these cases, what you need is a cost-volume-profit
analysis, also called a CVP analysis or a break-even
analysis.

Why should we study Break-Even Analysis?
To calculate the minimum amount of sales required in
order to be able to break even
To see how changes in output, selling price or costs will
affect profit levels
To calculate the level of output required to reach a
certain level of profit
To allow various scenarios (what-if) to be tested out
To aid forecasting and planning
New Product Development

General Expansion of Current Service Line

Forecasting (Can I do that many screenings to break even?)

Useful as a First Step in Setting Price and Making Financial
Decisions
It is also helpful in:
What is a (Cost/Volume/Profit) CVP analysis?
It is the study of the effects of output volume on revenue
(sales), expenses (costs), and net income (net profit).

It provides a simple means of measuring profits and
losses at different levels of output.

sales revenues and total costs are analysed for each
different level of production

It also shows what happens to the profit if the volume of
business increases above the break-even point, or
decreases below the break-even point.

Break - Even Analysis (Cost/Volume/Profit Analysis)
This is a planning and control technique.

PLANNING:
Helps to make informed decisions about pricing your product or
service and the cost to produce it. Breakeven Analysis, in the
context of Production planning, also addresses the decision of
whether to make or buy a product.

Making the product involves two cost elements:
Fixed costs such as machine renting cost and operation expenses
Variable costs such as raw material cost

Buying the product involves only one cost element, the selling price.
However, the price may either be constant or variable based on the
quantity.


Break - Even Analysis
(Cost/Volume/Profit Analysis)

CONTROL:
compare your actual results with those that you have
forecast. (For example, your restaurant may require
you to sell 10,000 meals at $10.00 per meal =
$100,000 in order to break even annually. This
works out to 192 meals a week or 28 per day. If on
the first day of operation you sell 30 mealsyou are
on track to break even!)
Assumptions of CVP Analysis
Expenses can be classified as either variable or fixed.

CVP relationships are linear over a wide range of production and
sales.

Sales prices, unit variable cost, and total fixed expenses will not
vary within the relevant range.

Volume is the only cost driver.

The relevant range of volume is specified and Inventory levels will
be unchanged.

The sales mix remains unchanged during the period.
Costs
Total Costs (TC) = Fixed Costs (FC)+ Variable Costs
(VC)

Average Costs = TC/Output (Q) [AC (unit costs) show
the amount it costs to produce one unit of output on
average]

Marginal Costs (MC) = the cost of producing one extra
or one fewer units of production MC = TC
n
TC
n-1

Fixed and Variable Costs
Fixed costs, incurred after the decision to enter into a business
activity is made, are not directly related to the level of production.
Fixed costs include, but are not limited to, depreciation on
equipment, interest costs, taxes and general overhead expenses.
Total fixed costs are the sum of the fixed costs.

Variable costs change in direct relation to volume of output. They
may include cost of goods sold or production expenses such as
labor and power costs, feed, fuel, veterinary, irrigation and other
expenses directly related to the production of a commodity or
investment in a capital asset. Total variable costs (TVC) are the
sum of the variable costs for the specified level of production or
output. Average variable costs are the variable costs per unit of
output or of TVC divided by units of output.
Variable Cost (Further explained)
For most small businesses, it is relatively easy to
determine the variable cost per unit.

What you want to determine is how much it costs you in
terms of direct material and direct labour to produce your
product or service.

Once you know the variable cost per unit, this becomes a
good guide to you in the pricing decision. Obviously, if
you price your product under your variable cost per unit,
you will lose money each time you sell one unit. The
more you sell, the more money you lose.
Total Revenue
Total Revenue also known as turnover, sales revenue or
sales = Price x Quantity Sold
TR = Price (P) x Quantity Sold (Q)

Price can be raised or lowered to change revenue (price elasticity
of demand is important here)
Different pricing strategies can be used (penetration,
psychological, etc.)

Quantity Sold can be influenced by amending the elements of the
marketing mix 7 Ps (Product, Price, Place, Promotion, People,
Process, Physical Evidence)

Break-Even Analysis
Links of break even to pricing strategies and elasticity
Penetration pricing high volume, low price (more
sales to break even)

Market Skimming high price low volumes (fewer
sales to break even)

Elasticity what is likely to happen to sales when prices
are increased or decreased?
Break Even Analysis
Importance of Price Elasticity of Demand:

Higher prices might mean fewer sales to break even but
those sales may take a longer time to achieve

Lower prices might encourage more customers but higher
volume needed before sufficient revenue generated to break
even
The Break-Even Point
The break-even point is the point in the volume of
activity where the organizations revenues and
expenses are equal.
Sales 250,000 $
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 100,000
Net income - $
Break-Even Analysis
Break-even analysis can be approached in three
ways:
1. Equation method.
2. Contribution margin method.
3. Graphical analysis.

Equation Method
Equation Method
Profits = Sales (Variable expenses + Fixed expenses)
Sales = Variable expenses + Fixed expenses + Profits
OR
At the break-even point
profits equal zero.
Break-Even Analysis
Here is the information from Wind Bicycle Co.:
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
Net operating income 20,000 $
Sales revenue Variable expenses Fixed expenses = Profit
Unit
sales
price
Sales
volume
in units

Unit
variable
expense
Sales
volume
in units

($500 X) ($300 X) $80,000 = $0
($200X) $80,000 = $0
X = 400
Equation Method
We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits
$500Q = $300Q + $80,000 + $0

Where:
Q = Number of bikes sold
$500 = Unit selling price
$300 = Unit variable expense
$80,000 = Total fixed expense
Equation Method
We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits
$500Q = $300Q + $80,000 + $0
$200Q = $80,000
Q = $80,000 $200 per bike
Q = 400 bikes
Equation Method
We can also use the following equation to compute
the break-even point in sales dollars.
Sales = Variable expenses + Fixed expenses + Profits
X = 0.60X + $80,000 + $0
Where:
X = Total sales dollars
0.60 = Variable expenses as a % of sales
$80,000 = Total fixed expenses
X = 0.60X + $80,000 + $0
0.40X = $80,000
X = $80,000 0.40
X = $200,000
Contribution Margin Method
Contribution Margin Method
The contribution margin method is a variation
of the equation method.
Fixed expenses
Unit contribution margin
=
Break-even point
in units sold
Fixed expenses
CM ratio
=
Break-even point in
total sales dollars
Total Per Unit
Sales (500 bikes) 250,000 $ 500 $
Less: variable expenses 150,000 300
Contribution margin 100,000 200 $
Less: fixed expenses 80,000
Net operating income 20,000 $
WIND BICYCLE CO.
Contribution Income Statement
For the Month of June
Contribution Margin (CM) is the amount remaining
from sales revenue after variable expenses have been
deducted.
Contribution-Margin Approach
Total Per Unit
Sales (500 bikes) 250,000 $ 500 $
Less: variable expenses 150,000 300
Contribution margin 100,000 200 $
Less: fixed expenses 80,000
Net operating income 20,000 $
WIND BICYCLE CO.
Contribution Income Statement
For the Month of June
CM goes to cover fixed expenses.
Contribution-Margin Approach
Total Per Unit
Sales (500 bikes) 250,000 $ 500 $
Less: variable expenses 150,000 300
Contribution margin 100,000 200 $
Less: fixed expenses 80,000
Net operating income 20,000 $
WIND BICYCLE CO.
Contribution Income Statement
For the Month of June
After covering fixed costs, any remaining CM
contributes to income.
Contribution-Margin Approach
Contribution Margin Ratio
The contribution margin ratio is:




Total CM
Total sales
CM Ratio =
Or, in terms of units, the contribution
margin ratio is:


Unit CM
Unit selling price
CM Ratio =
Quick Check
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.
What is the break-even sales in units?
a. 872 cups
b. 3,611 cups
c. 1,200 cups
d. 1,150 cups
Quick Check
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month
is $1,300. 2,100 cups are sold each month on
average. What is the break-even sales in units?
a. 872 cups
b. 3,611 cups
c. 1,200 cups
d. 1,150 cups
Fixed expenses
Unit contribution margin
Break-even =
$1,300
$1.49 per cup - $0.36 per cup
=
$1,300
$1.13 per cup
= 1,150 cups
=
Quick Check
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.
What is the break-even sales in dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129
Quick Check
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.
What is the break-even sales in dollars?
a. $1,300
b. $1,715
c. $1,788
d. $3,129
Fixed expenses
CM Ratio
Break-even sales =
$1,300
0.758
= $1,715
=
Target Profit Analysis
Suppose Wind Co. wants to know how many bikes
must be sold to earn a profit of $100,000.

We can use our CVP formula to determine the sales
volume needed to achieve a target net profit
figure.


Sales = Variable expenses + Fixed expenses + Profits
$500Q = $300Q + $80,000 + $100,000

$200Q = $180,000

Q = 900 bikes
We can determine the number of bikes that must be
sold to earn a profit of $100,000 using the
contribution margin approach.
Fixed expenses + Target profit
Unit contribution margin
=
Unit sales to attain
the target profit
$80,000 + $100,000
$200 per bike
= 900 bikes
Quick Check
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. How many cups of coffee would have to
be sold to attain target profits of $2,500 per month?
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups
Quick Check
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is $0.36.
The average fixed expense per month is $1,300. How
many cups of coffee would have to be sold to attain
target profits of $2,500 per month?
a. 3,363 cups
b. 2,212 cups
c. 1,150 cups
d. 4,200 cups
Fixed expenses + Target profit
Unit contribution margin
Unit sales to attain
target profit
$1,300 + $2,500
$1.49 - $0.36
=
$3,800
$1.13
= 3,363 cups
=
=
The Margin of Safety
Excess of budgeted (or actual) sales over the break-even
volume of sales. The amount by which sales can drop
before losses begin to be incurred.
Margin of safety = Total sales - Break-even sales
Lets calculate the margin of safety for Wind.
The Margin of Safety
Wind has a break-even point of $200,000. If
actual sales are $250,000, the margin of safety
is $50,000 or 100 bikes.
Break-even
sales
400 units
Actual sales
500 units
Sales 200,000 $ 250,000 $
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income - $ 20,000 $
The margin of safety can be expressed as 20%
of sales: ($50,000 $250,000)
Break-even
sales
400 units
Actual sales
500 units
Sales 200,000 $ 250,000 $
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income - $ 20,000 $
Quick Check
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.
What is the margin of safety?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
Quick Check
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.
What is the margin of safety?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups
Margin of safety = Total sales Break-even sales
= 950 cups
= 2,100 cups 1,150 cups
or
950 cups
2,100 cups
Margin of safety
percentage
= = 45%
Operating Leverage
A measure of how sensitive net operating income
is to percentage changes in sales.
With high leverage, a small percentage increase
in sales can produce a much larger percentage
increase in net operating income.
Contribution margin
Net operating income
Degree of
operating leverage
=
Operating Leverage
Actual sales
500 Bikes
Sales 250,000 $
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income 20,000 $
$100,000
$20,000
= 5
Operating Leverage
With a operating leverage of 5, if Wind increases
its sales by 10%, net operating income would
increase by 50%.
Percent increase in sales 10%
Degree of operating leverage 5
Percent increase in profits 50%
Heres the verification!
Operating Leverage
Actual sales
(500)
Increased
sales (550)
Sales 250,000 $ 275,000 $
Less variable expenses 150,000 165,000
Contribution margin 100,000 110,000
Less fixed expenses 80,000 80,000
Net operating income 20,000 $ 30,000 $
10% increase in sales from
$250,000 to $275,000 . . .
. . . results in a 50% increase in
income from $20,000 to $30,000.
Quick Check
Coffee Klatch is an espresso stand in a downtown
office building. The average selling price of a cup of
coffee is $1.49 and the average variable expense per
cup is $0.36. The average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.
What is the operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92
Quick Check
Coffee Klatch is an espresso stand in a
downtown office building. The average selling price
of a cup of coffee is $1.49 and the average variable
expense per cup is $0.36. The average fixed expense
per month is $1,300. 2,100 cups are sold each month
on average. What is the operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92
Contribution margin
Net operating income
Operating
leverage
=
$2,373
$1,073
= = 2.21
Actual sales
2,100 cups
Sales 3,129 $
Less: Variable expenses 756
Contribution margin 2,373
Less: Fixed expenses 1,300
Net operating income 1,073 $
Quick Check
At Coffee Klatch the average selling price of a cup of
coffee is $1.49, the average variable expense per cup is
$0.36, and the average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.

If sales increase by 20%, by how much should net
operating income increase?
a. 30.0%
b. 20.0%
c. 22.1%
d. 44.2%
Quick Check
At Coffee Klatch the average selling price of a cup
of coffee is $1.49, the average variable expense per cup
is $0.36, and the average fixed expense per month is
$1,300. 2,100 cups are sold each month on average.
If sales increase by 20%, by how much should net
operating income increase?
a. 30.0%
b. 20.0%
c. 22.1%
d. 44.2%
Percent increase in sales 20.0%
Degree of operating leverage 2.21
Percent increase in profit 44.20%
Graphical Analysis
Volume in Units
C
o
s
t
s

a
n
d

R
e
v
e
n
u
e

i
n

D
o
l
l
a
r
s

Total fixed costs
Preparing a CVP Chart
Total costs
Sales
Starting at the origin, draw the sales line
with a slope equal to the unit sales price.
Break-
even
Point
Relevant Range
The relevant range is the range of output (units produced and sold) that
the cost and pricing assumptions can reasonably be expected to hold.
$ of
Sales
and
Costs
# of units produced and sold
Total
Revenue
Total Costs
Fixed
Costs
Relevant Range
Relevant Range
If sales are expected to push the firm beyond its current physical
capacity, (beyond the relevant range) cost behaviour assumptions must
be revised.
$ of
Sales
and
Costs
# of units produced and sold
Total
Revenue
Total Costs
Fixed
Costs
Relevant Range
Break - Even Analysis
(Cost/Volume/Profit Analysis)
Number of units produced and sold
$ of
Sales
and
Costs
Total Revenue
Line
The slope of the
revenue line is
determined by the
price that you set
for your product
or service.
1 2
$20
$10
Sales revenue
when price per
unit is $5.00.
Break - Even Analysis
(Cost/Volume/Profit Analysis)
Number of units produced and sold
Total Revenue
Line
The slope of the
revenue line is
determined by the
price that you set
for your product
or service.
$ of
Sales
and
Costs
1 2
$7.50
$10
If variable cost
per unit is less
than price per unit,
there is a positive
contribution
margin.
Total Variable
Cost
Contribution Margin per unit = $2.50
Break Even Analysis
Costs/Revenue
Output/Sales
FC
VC
TC
TR (p = 2)
Q1 Q2
Assume
current sales
at Q2.
Margin of Safety
Margin of
safety shows
how far sales
can fall before
losses made. If
Q1 = 1000 and
Q2 = 1800,
sales could fall
by 800 units
before a loss
would be
made.
TR (p = 3)
Q3
A higher price
would lower the
break even
point and the
margin of safety
would widen.
x units
Break-even
output
margin of
safety






The margin of safety
The difference between actual output and the break-even
output is known as the margin of safety
Limitations of Break-Even Analysis
Its accuracy depends upon the accuracy of the data used

Forecasting the future is difficult, especially long term

It assumes there is a simple relationship between
variable costs and sales (linear Relationship)

Sales income does not necessarily rise in a constant
relationship to sales volume

External constraints have to be recognised
Summary
The break-even point occurs when total sales revenue
matches total costs.

The break-even point can be worked out either
numerically or graphically.

Break-even analysis is a very useful tool for businesses to
use although it does have some limitations.

Break-even analysis can be an effective tool in
determining the cost effectiveness of a product, Required
quantities to avoid loss, Use as a comparison tool for
making a decision.


THANK YOU
Equation Technique
Net income equals zero at the break-even point.
Sales
Variable expenses
Fixed expenses
Zero net income (break-even point) =


Equation Technique
$5N $4N $8,000 = 0
$1N = $8,000
N = $8,000 $1
N = 8,000 Units
Let N = number of units to be sold to break even
Equation Technique
S 0.80S $8,000 = 0
.20S = $8,000
S = $8,000 .20
S = $40,000
Let S = sales in dollars needed to break even
Contribution Margin Example
Luis and Tom manufacture a device that allows users
to take a closer look at icebergs from a ship. The usual
price for the device is $100. Variable costs are $70 per
unit. They receive a proposal from a company in
Newfoundland to sell 20,000 units at a price of $85.
There is sufficient capacity to produce the order. How
do we analyze this situation?

$85 $70 = $15 contribution margin.
$15 20,000 units = $300,000 (total increase in
contribution margin)

Contribution Margin Income Statement
Sales (20,000 x $85) $1,700,000
Variable costs
(20,000 x $70) (1,400,000)
Contribution margin $300,000
Breakeven Point Example
Assume that fixed expenses amount to $90,000.
How many devices must be sold at the regular
price of $100 to break even?
($100 Units sold) ($70 Units sold)
$90,000 = 0
Units sold = $90,000 $30 = 3,000
Changes in Fixed Costs and Sales Volume
Wind is currently selling 500 bikes per month. The
companys sales manager believes that an increase of
$10,000 in the monthly advertising budget would
increase bike sales to 540 units.

Should we authorize the requested increase in the
advertising budget?
Current Sales
(500 bikes)
Projected
Sales (540
bikes)
Sales 250,000 $ 270,000 $
Less: variable expenses 150,000 162,000
Contribution margin 100,000 108,000
Less: fixed expenses 80,000 90,000
Net operating income 20,000 $ 18,000 $
Changes in Fixed Costs and Sales Volume
Sales increased by $20,000, but net
operating income decreased by $2,000.
$80,000 + $10,000 advertising = $90,000
Per Unit Percent Ratio
Sales price $100 100 1.00
Variable expenses 70 70 .70
Contribution margin $ 30 30 .30
Contribution Margin
(Fixed expenses + Operating income)
Contribution margin per unit = Units
($90,000 + 0) $30 = 3,000 Units
Contribution Margin Formula
Change in Sales Price Example
Suppose that the sales price per device is $106 rather
than $100. What is the revised breakeven sales in units?
New contribution margin: $106 $70 = $36
$90,000 $36 = 2,500 units

Change in Variable Costs Example
Suppose that variable expenses per device are $75
instead of $70. Other factors remain unchanged.
$90,000 $25 = 3,600
$90,000 0.25 = $360,000
Change in Fixed Costs Example
Suppose that rental costs increased by $30,000.
What are the new fixed costs?
$90,000 + $30,000 = $120,000
What is the new breakeven point?
$120,000 $30 = 4,000 units
$120,000 0.30 = $400,000
Compute a margin of safety.
Margin of safety is the excess of expected sales over
breakeven sales.
Assume Luis and Toms breakeven point is 3,000
devices. Suppose they expect to sell 4,000 during the
period. What is the margin of safety?

4,000 3,000 = 1,000 units
1,000 $100 = $100,000
1,000 4,000 = 25%
$100,000 $400,000 = 25%
Contribution Margin
The contribution margin is the amount of money that is available
from the sale of each unit to cover the fixed costs of the firm.
Once those fixed costs are covered, any further units that are sold
will result in profit.
Operating Leverage
The ratio of fixed to variable costs is called operating
leverage.

In high leveraged companies, small changes in sales
volume result in large changes in net income.

Companies with less leverage are not affected as much
by changes in sales volume.