Cost-Volume-Profit Analysis

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Learning Objective 1

Understand the assumptions

underlying cost-volume-
profit
(CVP) analysis.

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 Cost-Volume-Profit Assumptions
and Terminology

1. Changes in the level of revenues and costs arise

only because of changes in the number of product
(or service) units produced and sold.
2. Total costs can be divided into a fixed component
and a component that is variable with respect to
the level of output.

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Cost-Volume-Profit Assumptions
and Terminology

3. When graphed, the behavior of total revenues

and total costs is linear (straight-line) in relation
to output units within the relevant range
(and time period).
4. The unit selling price, unit variable costs, and
fixed costs are known and constant.

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Cost-Volume-Profit Assumptions
and Terminology

5. The analysis either covers a single product or

assumes that the sales mix when multiple
products are sold will remain constant as the
level of total units sold changes.

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Cost-Volume-Profit Assumptions
and Terminology
Operating income
= Total revenues from operations
Cost of goods sold and operating costs
(excluding income taxes)
Net income = Operating income Income taxes

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Learning Objective 2

Explain the features

of CVP analysis.

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Essentials of Cost-Volume-Profit
(CVP) Analysis Example

Assume that the Pants Shop can purchase pants

for $32 from a local factory; other variable costs
amount to $10 per unit.
The local factory allows the Pants Shop to
return all unsold pants and receive a full $32
refund per pair of pants within one year.
The average selling price per pair of pants is $70
and total fixed costs amount to $84,000.
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Essentials of Cost-Volume-Profit
(CVP) Analysis Example

How much revenue will the business receive if

2,500 units are sold?
2,500 $70 = $175,000
How much variable costs will the business incur?
2,500 $42 = $105,000
$175,000 105,000 84,000 = ($14,000)
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Essentials of Cost-Volume-Profit
(CVP) Analysis Example

What is the contribution margin per unit?

$70 $42 = $28 contribution margin per unit
What is the total contribution margin when
2,500 pairs of pants are sold?
2,500 $28 = $70,000

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Essentials of Cost-Volume-Profit
(CVP) Analysis Example

Contribution margin percentage (contribution

margin ratio) is the contribution margin per
unit divided by the selling price.
What is the contribution margin percentage?
$28 $70 = 40%

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Essentials of Cost-Volume-Profit
(CVP) Analysis Example

If the business sells 3,000 pairs of pants,

revenues will be $210,000 and contribution
margin would equal 40% $210,000 = $84,000.

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Learning Objective 3

Determine the breakeven point

and output level needed to
achieve
a target operating income using
the equation, contribution
margin, 13
Breakeven Point

Variable Fixed
Sales expenses = expenses

Total revenues = Total costs

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Abbreviations

SP = Selling price
VCU = Variable cost per unit
CMU = Contribution margin per unit
CM% = Contribution margin percentage
FC = Fixed costs

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Abbreviations

Q = Quantity of output units sold

(and manufactured)
OI = Operating income
TOI = Target operating income
TNI = Target net income

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 Equation Method

(Selling price Quantity sold) (Variable unit cost

Quantity sold) Fixed costs = Operating income
Let Q = number of units to be sold to break even
$70Q $42Q $84,000 = 0
$28Q = $84,000
Q = $84,000 $28 = 3,000 units

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Contribution Margin Method

$84,000 $28 = 3,000 units

$84,000 40% = $210,000

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Graph Method
Breakeven
378
336
294 e n ue
Rev
252 osts
$(000)

l c
210 To ta
168
126 Fixed costs
84
42
0
0 1000 2000 3000 4000 5000
Units
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Target Operating Income

(Fixed costs + Target operating income)

divided either by Contribution margin
percentage or Contribution margin per unit

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 Target Operating Income

Assume that management wants to have an

operating income of $14,000.
How many pairs of pants must be sold?
($84,000 + $14,000) $28 = 3,500
What dollar sales are needed to achieve this income?
($84,000 + $14,000) 40% = $245,000
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Learning Objective 4

Understand how income

taxes affect CVP analysis.

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Target Net Income
and Income Taxes Example

Management would like to earn

an after tax income of $35,711.
The tax rate is 30%.
What is the target operating income?
Target operating income
= Target net income (1 tax rate)
TOI = $35,711 (1 0.30) = $51,016
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Target Net Income
and Income Taxes Example

How many units must be sold?

Revenues Variable costs Fixed costs
= Target net income (1 tax rate)
$70Q $42Q $84,000 = $35,711 0.70
$28Q = $51,016 + $84,000
Q = $135,016 $28 = 4,822 pairs of pants
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Target Net Income
and Income Taxes Example

Proof:
Revenues: 4,822 $70 $337,540
Variable costs: 4,822 $42 202,524
Contribution margin $135,016
Fixed costs 84,000
Operating income 51,016
Income taxes: $51,016 30% 15,305
Net income $ 35,711
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Learning Objective 5

Explain CVP analysis

in decision making and
how sensitivity analysis helps
managers cope with uncertainty.

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Using CVP Analysis Example

Suppose the management anticipates

selling 3,200 pairs of pants.
Management is considering an advertising
campaign that would cost $10,000.
It is anticipated that the advertising will
increase sales to 4,000 units.
Should the business advertise?
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Using CVP Analysis Example

3,200 pairs of pants sold with no advertising:

Contribution margin $89,600
Fixed costs 84,000
Operating income $ 5,600
4,000 pairs of pants sold with advertising:
Contribution margin $112,000
Fixed costs 94,000
Operating income $ 18,000 28
Using CVP Analysis Example

Instead of advertising, management is

considering reducing the selling price
to $61 per pair of pants.
It is anticipated that this will increase
sales to 4,500 units.
Should management decrease the selling
price per pair of pants to $61?
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 Using CVP Analysis Example

3,200 pairs of pants sold with no change

in the selling price:
Operating income = $5,600
4,500 pairs of pants sold at a reduced selling price:
Contribution margin: (4,500 $19) $85,500
Fixed costs 84,000
Operating income $ 1,500
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Sensitivity Analysis and
Uncertainty Example

Assume that the Pants Shop can sell

4,000 pairs of pants.
Fixed costs are $84,000.
Contribution margin ratio is 40%.
At the present time the business cannot
handle more than 3,500 pairs of pants.
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Sensitivity Analysis and
Uncertainty Example

To satisfy a demand for 4,000 pairs, management

must acquire additional space for $6,000.
Should the additional space be acquired?
Revenues at breakeven with existing space are
$84,000 .40 = $210,000.
Revenues at breakeven with additional space are
$90,000 .40 = $225,000
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Sensitivity Analysis and
Uncertainty Example

Operating income at $245,000 revenues with

existing space = ($245,000 .40)
$84,000 = $14,000.
(3,500 pairs of pants $28) $84,000 = $14,000

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Sensitivity Analysis and
Uncertainty Example

Operating income at $280,000 revenues with

additional space = ($280,000 .40) $90,000
= $22,000.
(4,000 pairs of pants $28 contribution margin)
$90,000 = $22,000

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Learning Objective 6

Use CVP analysis to plan

fixed and variable costs.

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 Alternative Fixed/Variable Cost
Structures Example

Suppose that the factory the Pants Shop is using to

obtain the merchandise offers the following:
Decrease the price they charge from $32 to $25 and
charge an annual administrative fee of $30,000.
What is the new contribution margin?

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Alternative Fixed/Variable Cost
Structures Example

$70 ($25 + $10) = $35

Contribution margin increases from $28 to $35.
What is the contribution margin percentage?
$35 $70 = 50%
What are the new fixed costs?
$84,000 + $30,000 = $114,000
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Alternative Fixed/Variable Cost
Structures Example

Management questions what sales volume

would yield an identical operating income
regardless of the arrangement.
28x 84,000 = 35x 114,000
114,000 84,000 = 35x 28x
7x = 30,000
x = 4,286 pairs of pants
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Alternative Fixed/Variable Cost
Structures Example

Cost with existing arrangement

= Cost with new arrangement
.60x + 84,000 = .50x + 114,000
.10x = $30,000 x = $300,000
($300,000 .40) $ 84,000 = $36,000
($300,000 .50) $114,000 = $36,000
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Learning Objective 7

Apply CVP analysis to a

company
producing different products.

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Effects of Sales Mix on Income

Pants Shop Example

Management expects to sell 2 shirts at $20 each
for every pair of pants it sells.
This will not require any additional fixed costs.

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Effects of Sales Mix on Income

Contribution margin per shirt: $20 $9 = $11

What is the contribution margin of the mix?
$28 + (2 $11) = $28 + $22 = $50

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Effects of Sales Mix on Income

$84,000 fixed costs $50 = 1,680 packages

1,680 2 = 3,360 shirts
1,680 1 = 1,680 pairs of pants
Total units = 5,040

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Effects of Sales Mix on Income

What is the breakeven in dollars?

3,360 shirts $20 = $ 67,200
1,680 pairs of pants $70 = 117,600
$184,800

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Effects of Sales Mix on Income

What is the weighted-average budgeted

contribution margin?
Pants: 1 $28 + Shirts: 2 $11
= $50 3 = $16.667

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Effects of Sales Mix on Income

The breakeven point for the two products is:

$84,000 $16.667 = 5,040 units
5,040 1/3 = 1,680 pairs of pants
5,040 2/3 = 3,360 shirts

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Effects of Sales Mix on Income

Sales mix can be stated in sales dollars:

Pants Shirts
Sales price $70 $40
Variable costs 42 18
Contribution margin $28 $22
Contribution margin ratio 40% 55%

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Effects of Sales Mix on Income

Assume the sales mix in dollars

is 63.6% pants and 36.4% shirts.
Weighted contribution would be:
40% 63.6% = 25.44% pants
55% 36.4% = 20.02% shirts
45.46%

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Effects of Sales Mix on Income

Breakeven sales dollars is $84,000

45.46% = $184,778 (rounding).
$184,778 63.6% = $117,519 pants sales
$184,778 36.4% = $ 67,259 shirt sales

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Learning Objective 8

Distinguish between
contribution margin
and gross margin.

50
 Contribution Margin versus
Gross Margin

Contribution income statement emphasizes

contribution margin.
Financial accounting income statement
emphasizes gross margin.

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THANK YOU

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