Chapter 20

Cost-VolumeProfit Analysis

Learning Objectives
1. Determine how changes
in volume affect costs
2. Calculate operating
income using
contribution margin and
contribution margin
ratio
3. Use cost-volume-profit
(CVP) analysis for profit
planning
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Learning Objectives
4. Use CVP analysis to
perform sensitivity
analysis
5. Use CVP analysis to
calculate margin of
safety, operating
leverage, and
multiproduct breakeven
points
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Learning Objective 1

Determine how changes

in volume affect costs

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How Do Costs Behave When

There Is a Change in Volume?
Some costs change as the volume of sales
increases or decreases. Other costs are
not affected by changes in volume.
Different types of costs are:
Variable costs
Fixed costs
Mixed costs

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Variable Costs
Variable costs remain constant per unit
but change in total as volume changes.

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Variable Costs

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Fixed Costs

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Fixed Costs

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Fixed Costs

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Mixed Costs
Mixed costs have both fixed and variable
components.

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Mixed Costs

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High-Low Method
A method to separate mixed costs into
variable and fixed components is the highlow method.

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High-Low Method
Use three steps to separate the variable
and fixed costs.
Step 1: Identify the highest and lowest
levels of activity and calculate the variable
cost per unit.

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High-Low Method
Now that we have calculated the variable
costs per unit, we can calculate the
portion of the mixed costs that relates to
the fixed costs.
Step 2: Calculate the total fixed costs.

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High-Low Method
Using the variable costs per unit and the
fixed costs per unit, we can determine the
total mixed costs at various levels of
productivity.
Step 3: Create and use an equation to
show the behavior of a mixed cost.

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Relevant Range and Relativity

The relevant range is the range of volume
where total fixed costs and variable costs
per unit remain constant.

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Learning Objective 2

Calculate operating income

using contribution margin
and contribution margin
ratio

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What Is Contribution Margin, And How Is

It Used to Compute Operating Income?
A traditional income statement classifies
costs by function:
Product costs
Period costs

A contribution margin income statement

classifies costs by behavior:
Variable costs
Fixed costs

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Contribution Margin
The difference between net sales revenue
and variable costs is the contribution
margin.
It is called contribution margin because it
is the amount that contributes to covering
fixed costs.

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Unit Contribution Margin

The contribution margin can be expressed
as a unit amount.
Note: The terms unit contribution margin
and contribution margin per unit are used
interchangeably.

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Contribution Margin Ratio

A third way to express contribution margin
is as a ratio.
Contribution margin ratio is the ratio of
contribution margin to net sales revenue.

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Contribution Margin Income Statement

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Learning Objective 3

Use cost-volume-profit
(CVP) analysis for profit
planning

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How Is Cost-Volume-Profit (CVP)

Analysis Used?
Managers use information about cost
behavior to make business decisions.
Cost-volume-profit (CVP) analysis is a
planning tool that looks at the
relationships among costs and volume and
how they affect profits (or losses).

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Assumptions
The price per unit does not change as
volume changes.
Managers can classify each cost as
variable, fixed, or mixed.
The only factor that affects total costs is
change in volume, which increases or
decreases variable and mixed costs.
Fixed costs do not change.
There are no changes in inventory levels.
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Target ProfitThree Approaches

CVP analysis can be used to estimate the
amount of sales needed to achieve a
target profit.
There are three methods of estimated
sales required to make a profit:
Equation approach
Contribution margin approach
Contribution margin ratio approach
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The Equation Approach

An equation can be used to estimate the
number of units a company needs to sell
to achieve target profit or total sales
revenue.

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The Equation Approach

If Smart Touch Learning desires a target
profit of $6,000, using the equation
approach, it finds it needs to sell 80 units.

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The Contribution Margin Approach

The contribution margin approach is a
shortcut method of computing the
required sales in units.
The equation approach is rewritten to
derive the following equation:

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Contribution Margin Ratio Approach

The contribution margin ratio approach computes required
sales in terms of sales dollars rather than in units.

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Breakeven PointA Variation of

Target Profit
The breakeven point calculation is a
variation of the target profit calculation.
The breakeven point is the point at which
total revenues equal total costs.
The same three approaches used for
target profit can be used to determine the
breakeven point.

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Breakeven PointA Variation of

Target Profit

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CVP GraphA Graphic Portrayal

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Learning Objective 4

Use CVP analysis to

perform sensitivity
analysis

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How Is CVP Analysis Used for

Sensitivity Analysis?
Managers can use CVP relationships to
conduct sensitivity analysis.
Sensitivity analysis is a what if technique
that estimates profit or loss results if sales
price, cost, volume, or underlying
assumptions change.

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Changes in the Sales Price

If the sales price changes from $500 to
$475, the number of units needed to
breakeven increases from 54 to 60.

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Changes in Variable Costs

If one of Smart Touch Learnings suppliers
raises prices and variable costs increase
from $275 to $285, the number of units
needed to break even increases from
54 to 56.

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Changes in Fixed Costs

If Smart Touch Learnings fixed costs
increase from $12,000 to $15,000, the
number of units needed to break even
increases from 54 to 67.

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How Is CVP Analysis Used for

Sensitivity Analysis?

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Learning Objective 5

Use CVP analysis to

calculate margin of safety,
operating leverage, and
multiproduct breakeven
points

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What Are Some Other Ways CVP

Analysis Can Be Used?
CVP analysis can be used for estimating
target profits and breakeven points, as
well as sensitivity analysis.
Three additional applications of CVP are:
Margin of safety
Operating leverage
Sales mix

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Margin of Safety
Margin of safety is the excess of expected
sales over breakeven sales.
Used to evaluate the risk of current
operations and their plans for the future.

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Operating Leverage
The cost structure of a company is the
proportion of fixed costs to variable costs.
Operating leverage predicts the effects that
fixed costs will have on changes in
operating income when sales volume
changes.
The degree of operating leverage can be
measured by dividing the contribution
margin by the operating income.

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Operating Leverage

For Company A, the percentage change in

operating income will be 2.5 times the
percentage change in sales.
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Sales Mix
Most companies sell more than one
product.
Sales price and variable costs differ for
each product.
Sales mix, or product mix, is the
combination of products that make up
total sales.

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Sales Mix

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