COST-VOLUME-PROFIT

RELATIONSHIPS
Cost-volume-profit (CVP) analysis helps managers understand the interrelationships
among cost, volume, and profit by focusing their attention on the interactions among the
prices of products, volume of activity, per unit variable costs, total fixed costs, and mix of
products sold. It is a vital tool used in many business decisions such as deciding what
products to manufacture or sell, what pricing policy to follow, what marketing strategy to
employ, and what type of productive facilities to acquire.

The Basics of Cost-Volume-Profit (CVP) Analysis

Contribution Margin
Contribution margin is used first to cover fixed expenses.
margin contributes to net operating income.

Any remaining contribution

Sales, variable expenses, and contribution margin can also be expressed on a per unit basis.

CVP Relationships in Equation Form

If the company sells a single product, we can express the sales and variable expenses as
shown in the blue and brown boxes. Sales are equal to the quantity sold (Q) times the selling
price per unit sold (P), and variable expenses are equal to the quantity sold (Q) times the
variable expenses per unit (V).

Profit = (P Q V Q) Fixed expenses

Profit = (P V) Q Fixed expenses
Unit contribution margin is equal to the unit selling price less the unit variable expenses.
Using the equations we have developed, we can express the Unit CM as P less V.
If we rearrange the basic profit equation for a single product company and we can see that
profit is equal to the unit CM times the quantity sold less the fixed expenses.

CVP Relationships in Graphic Form

The break-even point is where the total revenue and total expenses lines intersect.
The profit or loss at any given sales level is measured by the vertical distance between the
total revenue and the total expenses lines.

COST-VOLUME-PROFIT
RELATIONSHIPS
An even simpler form of the CVP graph is called the profit graph. The graph is based on the
equation profit equals Unit Contribution Margin times quantity sold less total fixed costs.

Contribution Margin Ratio

The contribution margin ratio is calculated by dividing the total contribution margin by
total sales.

Target Profit and Break-Even Analysis

Target Profit Analysis
Unit sales to attainTarget profit + Fixed expenses
=
the target profit
CM per unit
Target profit expressed in units sold. For this equation we divide the sum of the desired
target profit plus total fixed expenses by the contribution margin per unit.

The formula method is summarized on this slide. It can also be used to compute the dollar
sales needed to attain a target profit.

Break-even in Unit Sales

Profits = Unit CM Q Fixed expenses
To find the break-even point, we set profits equal to zero, and solve for the unknown
quantity, Q.
For example, suppose Mitsubishi Company wants to know how many cars must be sold to
break-even (earn a target profit of $0.
Suppose that Mitsubishi has a unit contribution margin of $300 equal to 40%, and total fixed
expenses of $100,000.
Now, lets use the formula method to calculate the dollar sales at the break-even point.

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RELATIONSHIPS
If we elect to use the formula method, we calculate the same $250,000 sales at the breakeven point.

The Margin of Safety

Margin of safety in dollars = Total sales

Break-even

sales
The margin of safety helps management assess how far above or below the break-even
point the company is currently operating. To calculate the margin of safety in dollars, we
take total current sales and subtract break-even sales.
Thus, Mitsubishi Companys margin of safety supposing that he has total sales of $320,000
for the year is $70,000 computed below:
Margin of safety in dollars =$320,000 - $250,000
=$70,000

Operating Leverage
Operating leverage is a measure of how sensitive net operating income is to percentage
changes in sales. The degree of operating leverage is a measure, at any given level of sales,
of how a percentage change in sales volume will affect profits. It is computed by dividing
contribution margin by net operating income.

Key Assumptions of CVP Analysis

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Selling price is constant.

Costs are linear and can be accurately divided into variable (constant per
unit) and fixed (constant in total) elements.
In multiproduct companies, the sales mix is constant.
In manufacturing companies, inventories do not change (units produced =
units sold).