COST-VOLUME-PROFIT ANALYSIS

What effect on profit can United Airline expect if it adds a flight on the Chicago to New York
route?

How will NBC’s profit change if the ratings increase for its evening news program?

How many patient days of care must Massachusetts Generals Hospital provide to break
even for the year?

What happens to this break-even point patient load if the hospital leases a new
computerized system for patient records?

Each of these questions concerns the effect on costs and revenues when the organization
activity changes.

The analytical technique used by managerial accountants to address these questions is

called cost-volume-profit analysis, often called CVP for short.

CVP analysis can be extended to cover the effects on profit of changes in selling prices,
service fees, costs, income-tax rates, and the organization’s mix of products or services.

What will happen to profit, for example, if the New York Yankees raise ticket prices for
stadium seats?

In short, CVP analysis provides management with a comprehensive overview of the effects
on revenue and costs of all kinds of short-run financial changes.

CVP is also in non-profit organizations.

E.g. the State of Florida gains approximately 1,000 people a day in population, the state’s
political leaders must analyze the effects of this change on sales-tax revenues and the cost
of providing services, such as education, transportation, and police protection.

Illustration of Cost-Volume-Profit Analysis

Projected Expenses and Revenue

Fixed expenses per month:

Theater rental ---------------------------------------------------- $ 10,000
Employees’ salaries and fringe benefit ---------------------- 8,000
Actors’ wages ----------------------------------------------------- 15,000
(to be supplemented with local volunteer talent)
Production crew’s wages -------------------------------------- 5,600
(to be supplemented with local volunteers)
Playwrights’ royalties for use of plays ---------------------- 5,000
Insurance --------------------------------------------------------- 1,000
Utilities --- fixed portion --------------------------------------- 1,400
Advertising & promotion -------------------------------------- 800
Administrative expenses -------------------------------------- 1,200
Total fixed expenses per month ----------------------------- $ 48,000

Variable expenses per ticket sold:

City’s charge per ticket for use of theater ------------------- $8
Other miscellaneous expenses (e.g. printing of playbills
and tickets, variable portion of utilities) --------- 2
Total variable cost per ticket sold ----------------------------- $ 10

Revenue:
Price per ticket ------------------------------------------ $ 16

Note the importance of cost behavior in cost categorization: fixed and variable.
The Break-even Point

Break-even point is the volume of activity where the organization’s revenues and expenses
are equal.

Total contribution margin is the total sales revenue minus total variable expenses. This is
the amount of revenue that is available to contribute to covering fixed expenses after all
variable expenses have been covered.

Break-even volume of tickets as follows:

Fixed ExpensesUnit contribution margin =Break-even point (in units)

Fixed ExpensesContribution-margin ratio =Break-even point in sales dollars

Contribution-margin ratio = the unit contribution margin divided by the unit sales price.

Graphing Cost-Volume-Profit Relationships

While the break-even point conveys useful information to management, it does not show
how profit changes as activity changes.

To capture the relationship between profit and volume activity, a CVP graph is commonly
used.

The graph shows relevant range, which is the range of activity within which management
expects the theater to operate.

If the theater building seats 450 people, the agreement calls for 20 performances
during each play’s one-month run, thus, the maximum Total
number
expensesof for tickets that can be sold
8,000 tickets, $ 128,000
each month is 450 × 20 = 9,000. The organization’s break-even point is quite close to the
maximum possible sales volume. This could be a cause of concern in a nonprofit
organization operating on limited resources.

What could the management do to improve thisTotal situation?

fixed
One possibility is to
renegotiate with the city to schedule additional performances.
expense However, this might not be

feasible, because the actors need some rest each week. Also additional performances
would likely entail additional costs, such as increased theater-rental expenses and
increased compensation for the actors and production crew. Other possible solutions are to
raise ticket prices or reduce costs.

The CVP graph will not resolve this potential problemRelevant

for the management of this
theater. However, the graph will direct management’s attention to the situation.
Range

Target Net Profit

The theater would like to run free workshops and classes for young actors and aspiring
playwrights. This program would cost $ 3,600 per month in fixed expenses, including
teachers’ salaries and rental space at a local college. No variable expenses would be
incurred. If the theater could make a profit of $ 3,600 per month on its performances, the
workshop could be opened. How many theater tickets must be sold during each play’s one-
month run to make a profit of $3,600?

The desired profit level of $ 3,600 is called a target net profit (or income).

Contribution margin approach:

Fixed expense +Target net profitUnit contribution margin=Number of sales unit required to
earn target net profit

$ 48,000 +$ 3,600$ 6=8,600 tickets

$ 48,000 +$ 3,600.375=$ 137,600,

Where the contributing margin ratio = $ 6$ 16= .375

Applying CVP Analysis

Safety Margin of an enterprise is the difference between budgeted sales revenue and the
break-even sales revenue.

Suppose theater’s business manager expects every performance of each play to be sold
out. Then budgeted monthly sales revenue is $ 144,000 (450 seats x 20 performances of
each play x $ 16 per ticket). Since breakeven revenue is $ 128,000, the organization’s
safety margin is $ 16,000 ($144,000 - $ 128,000). The safety margin gives management a
feel for how close projected operations are to the organization’s break-even point.

Changes in Fixed Expense:

Suppose the business manager is concerned that the estimate for fixed utilities expenses, $
1,400 per month, is too low. What would happen to the break-even point if fixed utilities
expenses prove to be $ 2,600 instead?

The estimate of fixed expenses has increased by 2.5 percent, since $ 1,200 is 2.5 percent
of $ 48,000. Notice that break-even point also increased by 2.5 percent (200 tickets is 2.5
percent of 8,000 tickets). This relationship will always exist.

Donations to Offset Fixed Expenses

Nonprofit organizations often receive cash donations from people or organizations desiring
to support a worthy cause. A donation is equivalent to a reduction in fixed expenses, and it
reduces the organization’s break-even point. Suppose that various people pledge donations
amounting to $ 6,000 per month. The new break-even point is ($ 48,000 - $ 6,000)/$ 6 =
7,000 tickets.

Changes in the Unit Contribution Margin:

What would happen to Theater’s break-even point if miscellaneous variable expenses were
$ 3 per ticket instead of $ 2? Alternatively, what would be the effect of raising the ticket
price to $ 18?

Changes in Unit variable expenses:

Unit contribution margin reduces from $ 6 to $ 5, break-even point increases from 8,000
tickets to 9,600 tickets or from $ 128,000 to $ 153,600.

If this change in unit variable expenses actually occurs, it will no longer be possible for the
organization to break even. Only 9,000 tickets are available for each play’s one-month run
(450 seats x 20 performances).

Once again, CVP analysis will not solve this problem for management, but it will direct
management’s attention to potentially serious difficulties.

Changes in Sales Price:

Suppose the ticket price is raised from $ 16 to $ 18. This change will raise the unit
contribution margin from $ 6 to $ 8. The new break-even point will be 6,000 tickets ($
48,000 ÷ $ 8).

A $ 2 increase in the ticket price will lower the break-even point from 8,000 tickets to 6,000
tickets. Is this change desirable? A lower break-even point decreases the risk of operating
with a loss if sales are sluggish. However, the organization may be more likely to at least
break even with $ 16 ticket price than with an $ 18 ticket price. The reason is that the lower
ticket price encourages more people to attend the theater’s performance. Ultimately, the
desirability of the ticket-price increase depends on management’s assessment of the likely
reaction by theater patrons.

Management’s decision about the ticket price increase also will reflect the fundamental
goals of theater. This nonprofit drama organization was formed to bring contemporary
drama to the people of Seattle. The lower the ticket price, the more accessible the theater’s
productions will be to people of all income levels.

The point of this discussion is that CVP analysis provides valuable information, but it is only
one of several elements that influence management’s decisions.

Prediction Profit Given Expected Volume:

Suppose the management theater expects fixed monthly expense of $ 48,000 and unit
variable expenses of $10 per ticket. The organization’s board of trustee is considering two
different ticket prices, and the business manager has forecast monthly demand at each
price.
Ticket Price Forecast Monthly Demand

$ 16 9,000

$ 20 6,000

The difference in expected profit at the two tickets prices is due to two factors:

1. A different unit contribution margin, defined previously as unit sales price minus unit
variable expenses
2. A different sales volume
Expected total contribution margin at $ 20 ticket
price:

6,000 x ($20 - $10) $ 60,000

--------------------------------------------------
 Expected total contribution margin at $ 16 ticket
price:

9,000 x ($16 - $10) 54,000

--------------------------------------------------

Difference in total contribution margin $ 6,000

Interdependent Changes In Key Variables:

Suppose the board of trustees is choosing between ticket prices of $ 16 and $ 20, and the
business manager has projected demand as shown in the preceding section. A famous
retired actress who lives in Seattle has offered to donate $ 10,000 per month to theater if
the board wills set the ticket price at $ 16. The actress is interested in making the theater’s
performances affordable by as many people as possible. The facts are now as follows:
Ticket Price Unit Contribution Margin Forecast Monthly Demand Net Fixed Expenses

(after subtracting donation)

$ 16 $6 9,000 $ 38,000 ($ 48,000 - $ 10,000)

20 10 6,000 $ 48,000

Now, the difference in expected profit at the two ticket prices is due to three factors:

1. A different unit contribution margin

2. A different sales volume
3. A difference in the net fixed expenses, after deducting the donation

The theater will make $ 4,000 more in profit at the $16 price ($10,000 - $6,000).

CVP Analysis with Multiple Products

Most firms have a sales mix consisting come complexity to their CVP analyses.

Suppose the city of Seattle has agreed to refurbish 10 theater boxes in the historic theater
building. Each box has five seats, which are more comfortable and afford a better view of
the stage than the theater’s general seating. The board of trustees has decided to charge $
16 per ticket for general seating and $ 20 per ticket for box seats. These facts are
summarized as follows:

Seat Ticket Unit Variable Unit Contribution Seats in Seats Available per
Type Price Expense Margin Theater month

(20 performance)

Regular $ 16 $ 10 $6 450 9,000

Box 20 10 10 50 1,000

Weighted-average unit contribution margin = ($6 x 90%) + ($10 x 10%) = $ 6.40

Break-even point = Fixed expensesWeighted-average unit contribution margin

= $ 48,000$ 6.40
 = 7,500 tickets

The break-even point of 7,500 tickets must be interpreted in light of the sales mix. Theater
will break even for the month if it sells 7,500 tickets as follows:

Regular seats: 7,500 x 90% 6,750 tickets

Break-even
Box seats: 7,500 x 10% 750 tickets
sales in units

Total 7,500 tickets

The break-even
point of 7,500 tickets per month is valid only for the sales mix assumed in computing the
weighted-average unit contribution margin.

Assumptions Underlying CVP Analysis

For any CVP analysis to be valid, the following important assumptions must be reasonably
satisfied within the relevant range.

1. The behavior of total revenue is linear (straight-line). This implies that the price of
the product or service will not change as sales volume varies within the relevant
range.
2. The behavior of total expenses is linear (straight-line) over the relevant range. This
implies the following more specific assumptions.
a. Expenses can categorized as fixed, variable, or semivariable. Total fixed
expenses remain constant as activity changes, and the unit variable expense
remains unchanged as activity varies.
b. The efficiency and productivity of the production process and workers remain
constant.
3. In multiproduct organizations, the sales mix remains constant over the relevant
range.
4. In manufacturing firms, the inventory levels at the beginning and end of the period
are the same. This implies that the number of units produced during the period
equals the number of units sold.

Role of Computerized Planning Models and Electronic Spreadsheets

Since these variables are rarely known with certainty, it is helpful to run a CVP analysis
many times with different combinations of estimates. For example, theater’s business
manager might do the CVP analysis using different estimates for the ticket prices, sales mix
for regular and box seats, unit variable expenses, and fixed expenses. This approach is
called sensitivity analysis, since it provides the analyst with a feel for how sensitive the
analysis is to the estimates upon which it is based.

CVP Relationships and the Income Statement

Contribution Income statement vs. traditional Income Statement

Cost Structure and Operating Leverage

The cost structure of an organization is the relative proportion of its fixed and variable
costs.
An organization’s cost structure has significant effect on the sensitivity of its profit to
changes in volumes.

Operating Leverage

The extent to which an organization uses fixed costs in its cost structure is called operating
leverage.

The operating leverage is the greatest in firms with a large proportion of fixed costs, low
proportion of variable costs, and the resulting high contribution-margin ratio.

To physical scientist, leverage refers to the ability of a small force to move a heavy weight.

To the managerial accountant, operating leverage refers to the ability of the firm to
generate an increase in net income when sales revenue increases.

Operating Leverage = Contribution MarginNet Income

Break-even Point and Safety Margin

Since a firm with relatively high operating leverage has proportionally high fixed expenses,
the firm’s break-even point will be relatively high and the firm’s safety margin will be
relatively lower.

Labor-Intensive Production Processes versus Advanced Manufacturing Systems

A movement toward an advanced manufacturing environment often results in a higher

break-even point, lower safety margin, and higher operating leverage.

However, high-technology manufacturing systems often have greater throughput, thus

allowing greater potential for profitability.

Along with the increased potential for profitability comes increased risk.

In an economic recession, for example, a highly automated company with high fixed costs
will be less able to adapt to lower consumer demand than will a firm with a more labor-
intensive production process.

Cost Structure and Operating Leverage: A Cost-Benefit Issue

An organization’s cost structure plays an important role in determining its cost-volume-

profit relationships.

A firm with proportionally high fixed costs has relatively high operating leverage.

The result of high operating leverage is that the firm can generate a large percentage
increase in net income from a relatively small percentage increase in sales revenue.

On the other hand, a firm with high operating leverage has a relatively high break-even
point. This entails some risk to the firm.

CVP Analysis, Activity-Based Costing, and Advanced Manufacturing System

The contribution Income Statement:

Sales Volume 20,000 Units
 Sales Price $ 25

Unit variable costs:

Variable manufacturing $ 14

Variable selling and administrative 1

Total unit variable cost $ 15

Unit contribution margin $10

Fixed costs:

Fixed manufacturing $ 100,000

Fixed selling and administrative 50,000

Total fixed costs $ 150,000

Break-even point = $ 150,000$ 10 =15,000 units

Sales volume required to earn target net profit of $ 200,000 = $ 150,000+$ 200,000$ 10 =
35,000 units

These focus on sales volume as the sole revenue and cost driver.

The CVP analysis depends on a distinction between costs that are fixed and costs that are
variable with respect to sales volume.

The contribution Income Statement:

Sales Price $ 25

Unit variable costs:

Variable manufacturing $ 14

Variable selling and administrative 1

Total unit variable cost $ 15

Unit contribution margin $10

Fixed costs (fixed with respect to sales volume):

General factory overhead (including $ 60,000

depreciation on plant and equipment)

Setup (52 setups at $ 100 per setup)* 5,200

Inspection [(52)(21) inspections at $ 20 per 21,880

inspection]**

Material handling (1,080 hours at $12 per 12,960

hour)

Total fixed manufacturing costs $ 100,000

Fixed selling and administrative costs 50,000

Total fixed costs $ 150,000

*One setup per week

**Three inspections per day, seven days a week (52 weeks per year)

With the installation of a flexible manufacturing system and a move toward just-in-time
production:

Sales Price $ 25
 Unit variable costs:

Variable manufacturing $9

Variable selling and administrative 1

Total unit variable cost $ 10

Unit contribution margin $15

Fixed costs (fixed with respect to sales volume):

General factory overhead (including $ 184,000

depreciation on plant and equipment)

Setup (365 setups at $ 30 per setup)* 10,950

Inspection [365 inspections at $ 10 per 3,650

inspection]**

Material handling (100 hours at $14 per 1,400

hour)

Total fixed manufacturing costs $ 200,000

Fixed selling and administrative costs 50,000

Total fixed costs $ 250,000

Break-even point = $ 250,000$ 15 =16,667 units

Sales volume required to earn target net profit of $ 200,000 = $ 250,000+$ 200,000$ 15 =
30,000 units

Note that the break-even point increased with the introduction of the advanced
manufacturing system (from 15,000 to 16,667 units).

However, the number of sales units required to earn a target net profit of $ 200,000
declined (from 35,000 to 30,000 units).