Lecture note on Cost-Volume-Profit Analysis

Date: Sept 2005

Author: Prof. Dr. A.N.A.M. Boons / Drs. I. de Vries

Key learning objectives

• Being able to apply the basic model of Cost Volume Profit analysis and to calculate the Break Even
Point and the Break Even Revenue in two different ways.
• Understand the relationship between the Break Even Point, the Safety Margin and the Operating
Leverage and their usefulness to strategic decision making.
• Being able to calculate a target profit, also in a situation where some costs directly vary with
revenues.
• Understand how the basic model can be extended to incorporate the influence of taxes.
• Understand how to calculate the Cash Break Even Point and why this concept if useful for strategic
decision making.

The basic model

Cost-Volume-Profit (CVP) analysis is aimed to provide insight into the relations
between revenues, variable costs, fixed costs, volumes and product portfolio. In
essence, it is a model of the business activities which enables the manager to solve
planning problems within a relative short time span.

The basic model is based on a very simplified production process: one production
phase during which one product is produced within a certain volume range. The sales
price, the variable costs per unit and the fixed costs of this product are all known.
The cost-function of the basic model can be formulated as follows:

TC = vc * Q + FC
in which:
TC = total costs
vc = variable costs per unit of product
Q = production quantity
FC = fixed costs.

The revenue function can be formulated as:

TR = sp * Q
in which:
TR = total revenue
sp = selling price per unit of product
Q = selling quantity

Both the revenue-function and the cost-function are linear.

The so-called Break Even Point is central to the CVP-analysis. This is the production
and sales quantity at which the costs and revenues are equal. This point is easy to
determine in the basic model:

TR = TC
sp * Q = vc * Q + FC
( sp − vc) * Q = FC
FC
Qbep =
( sp − vc)

in which:
Qbep = Break Even Point in quantities.
The difference between the selling price and the variable costs per unit of product is
called the unit contribution margin. This metric can be put in the form of a ratio, the
contribution margin percentage, in two ways: (1) the contribution margin per unit
divided by the selling price and (2) the contribution margin per unit divided by the
variable costs.
The contribution margin is, therefore, the contribution to the profit after the fixed
costs have been earned back. The fixed costs are recovered when the BEP is attained.

Numerical example 1
During a fair ‘stroopwafels’ are sold for € 1.50 per packet containing 10 ‘wafels’. The
packets are purchased at a price of € 1.00 per packet. The rent of the stand
amounts to € 200 a day. The cost-function is as follows:

TC = 1* Q + 200
The revenue-function is as follows:

TR = 1.50 * Q
The Break Even Point can be calculated as follows:

200
Qbep = = 400
(1.50 − 1)
Next to the above way, the Break Even Point can be calculated by using the
contribution margin percentage (based on the variable costs):

200
Qbep = = 400
50%
The Break Even Revenue is then:

TRbep = 1 = 1.50 * 400 = 600

The Break Even Revenue can also be calculated by using the contribution margin
percentage (based on the selling price):

200
TRbep = = 600
33%

The patterns outlined in the numerical example are depicted in the following graph:

C-V-P

1600

1400

1200

1000
Revenue
800 Total costs

600

400

200

0
0 50 100 150 200 250 300 350 400 450 500 550 600 650 700 750 800 850 900 950

Units
 The calculations in the numerical example, as well as the graph, show that the Break
Even Point is reached when the sales and production volume amounts to 400 units and
the revenue amounts to € 600.

This model can be used to answer the following questions:

• At which sales volume, do costs equal revenues?
• What is the impact of an increased or decreased rent of the stand on profit and
the BEP?
• What is the impact of an increased or decreased selling price on profit and the
BEP?
• What is the impact of increased or decreased variable costs on profit and the BEP?

Safety Margin and Operating Leverage

The CVP-analysis offers an important bridge between the controller and the marketing
manager. The marketing manager should be able to estimate the expected sales
quantity based on a given selling price. This estimate could be compared with the BEP.
The proportion (difference) between the sales quantity estimate and the BEP is called
the Safety Margin. If the marketing manager estimated the sales of the stroopwafels
during the fair at 500 packets based on a selling price of € 1.50, the Safety Margin in
the numerical example 1 equals 20%: (500 - 400) / 500. Stated otherwise, the
expected sales quantity could decrease with 20% before the BEP will be reached.
This could also be expressed as follows: the Break Even Percentage (BEP / Revenue *
100%). In the numerical example the Break Even Percentage equals 80%, meaning
that the Break Even Point is equal to 80% of the sales quantity.
It will be clear that when the proportion of the fixed cost in the total costs decreases,
the Break Even Percentage decreases, or stated otherwise: the Safety Margin
increases. A company with a high Break Even Percentage or a low Safety Margin is
less flexible on the short term (incurs a higher risk) than a company with a low Break
Even Percentage or a high Safety Margin. This has to do with the relationship between
fixed costs and total costs. This ratio is generally specified as the Operating Leverage.

Numerical example 2

We compare two market traders with the same revenue and the same profit:

Johnny Andrew
Revenue (Q) 500 500
Selling price (sp) € 1.50 € 1.50
Revenue (TR) € 750.00 € 750.00
Variable costs per unit (vc) € 1.00 € 1.20
Total variable costs (TVC) € 500.00 € 600.00
Fixed costs (FC) € 200.00 € 100.00
Profit € 50.00 € 50.00

BEP 400 333

Safety margin 20% 33%
Break Even Percentage 80% 67%
Operating leverage 29% 14%
Contribution margin € 0.50 € 0.30

The market trader Johnny in numerical example 2 has a higher Safety Margin, a higher
Break Even Point and a higher Operating Leverage. This means that Johnny is at risk
sooner than Andrew, when the sales quantity decreases. On the other hand, when the
 sales quantity increases, Johnny adds to his profit € 0.50 per unit of product sold,
whereas Andrew only adds € 0.30. In the situation of a price war Johnny will sustain
for a longer time than Andrew. At a selling price between € 1.00 and € 1.20 Johnny
still adds margin to cover for his fixed cost, while Andrew does not. From a strategic
perspective it is important to have an idea of the cost structure (including the
Operating Leverage) of the competitor. When Johnny and Andrew are active in the
same markets, then Johnny could strike Andrew more severely with a selling price
decrease than the other side around.

The relation between the Operating Leverage and the Break Even Point can be
depicted graphically:

500

450

400

350

300
Break-even point

250

200

150

100

50

0
0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

Operating leverage

The basic model including Target Profit

With a small modification this basic model can be used to determine the so-called
‘Target Sales Quantity’, required to earn for instance a minimum amount of profit. The
adapted formula of the BEP is in that case:

FC + TP
Qbep =
( sp − vc)
in which:
TP = target profit, expressed in euros (or another currency).

If we continue with the numerical example 1, the calculation of the target sales

quantity can be illustrated as follows in the numerical example 3 underneath.

Numerical example 3

We would also like to earn some money by selling stroopwafels on the fair. Suppose
we wish to earn € 100 that day, how many packages of stroopwafels we would then
have to sell?

The cost function is then:

 TC = 1* Q + 200 + 100
The revenue function is in that case:

TR = 1.50 * Q
The Break Even Point can be calculated as follows:

200 + 100
Qbep = = 600
(1.50 − 1)
The Break Even Point can be calculated by using the contribution margin percentage
based on the variable costs:

200 + 100
Qbep = = 600
50%
The Break-Even revenue is in that case:

TRbep = 1.50 * 600 = 900

The Break-Even revenue can also be calculated by using the contribution margin
percentage based on the selling price:

200 + 100
TRbep = = 900
33%

A special kind of Target Profit is the Revenue-Dependent Target Profit. In this case,
some costs vary directly with the amount of revenue. Suppose that in ‘the fair
example’ the leaseholder lets out the stand at a minimum price of € 100 + 20% of
revenue. This basically means that the unit variable costs increase with 20% of the
selling price. Stated more generally:

TR = TC
sp . Q = vc * Q + FC + α * sp * Q
( sp − α * sp − vc) * Q = FC
FC
Qbep =
[ (1 − α ) sp − vc]
In the numerical example of the fair, the new BEP will be:1

100
Qbep = = 500
(1 − 0.2)1.50 − 1.00

The basic model including taxes

A philosopher once said that there are only two things certain in life: death and taxes.
In this paragraph, we will extend the basic model to incorporate the influence of taxes
over profit.
Before we start on that, a little reflection could be helpful. The Break Even Point is the
point at which the total costs (fixed and variable) and the total revenue are equal. This
means that no profit is made. Hence, no taxes over profit are levied either. This means
that the Break Even Point in a world with taxes equals the Break Even Point in a tax-
free world. In the mathematical derivation below we will check this statement.

1
This calculation can easily be checked: 500 packages of stroopwafels yield € 750 of revenue.
The total variable costs will in that case amount to € 500. When the fixed rent of the stand is
deducted from this amount, € 150 is left over. This equals 20% of € 750.
We abbreviate the tax-percentage to T. This means that taxes payable equal: T * (TR -
TC). The net profit is in that case: (1 - T) * (TR -TC). This leads to the following
derivation:
(1 − T ) * sp * Q = (1 − T ) * (vc * Q + FC )
( (1 − T ) * sp − (1 − T ) * vc ) * Q = (1 − T ) * FC
( (1 − T )( sp − vc) ) * Q = (1 − T ) * FC
(1 − T ) * FC
Qbep =
( (1 − T )( sp − vc) )
FC
Qbep =
( sp − vc)

Hence our statement is correct. This derivation is useful when we have to calculate a

target profit after taxes. In that case, however, the Break Even Point is calculated

slightly differently than in a tax-free world.

TP
TPT =
(1 − T )
in which:
TPT = Target Profit after Taxes.

The Break Even Point is then calculated as:

FC TP
Qbep T = +
( sp − vc) (1 − T )( sp − vc)
in which:
Qbep T = Break Even Point after taxes.

The complete derivation is now as follows:

 TP 
(1 − T ) * sp * Q = (1 − T ) * vc * Q + FC +
 (1 − T ) 

( (1 − T ) * sp − (1 − T ) * vc ) * Q = (1 − T ) *  FC + TP 
 (1 − T ) 

( (1 − T )( sp − vc) ) * Q = (1 − T ) *  FC + TP 
 (1 − T ) 
 TP 
(1 − T ) *  FC +
 (1 − T ) 
Qbep T =
( (1 − T )(sp − vc) )
FC TP
Qbep T = +
( sp − vc) ( (1 − T )( sp − vc) )

Numerical example 4

We continue with the numerical example 3. We would still like to earn € 100, but
this time we have to pay taxes over profit, which amount to 20%. This means that
 we should earn a profit of € 125 before taxes, because 20% of € 125 equals € 25.
We can solve this problem in two ways.

We increase the Target Profit to € 125 and use the ‘old formula’:

200 + 125
Qbep = = 650
(1.50 − 1)
We use the new formula:

200 100
Qbep T = + = 650
(1.50 − 1) ( (1 − 0.2)(1.50 − 1) )

The Cash Break Even Point

Based on the preceding it has become clear that the Break Even Point is a useful
concept for many decisions. But now suppose that the calculated Break Even Point is
higher than the forecasted revenue. In our first numerical example we have calculated
that we must sell 400 packages of stroopwafels in order to break even. Suppose now
that we have forecasted to sell only 300 packages. In the case of a one-day fair we
would then decide not to participate. But now suppose that we have made our
profession of selling stroopwafels at fairs and markets. Suppose next that the € 200 of
fixed costs consist of € 100 for the rent of the stand place and that the stand is our
own property, on which we depreciate € 100.
When the most recent prediction is not incidental but a trend (sales of stroopwafels at
fairs and markets continue to decrease), we have to decide whether we wish to
continue our life as being a market-trader. Suppose that we have decided to
discontinue this business. Is the calculated Break Even Point the right signal to
discontinue immediately?

The essence of this question is to determine the right moment to quit. The decision to
continue or to discontinue business can be taken based on the Break Even analysis.2
When deciding when to discontinue, we have to realize that by the absence of a future
perspective also the intention to replace the stand is gone. The replacement intention
is the only reason to take into account the depreciation costs of the stand in the total
fixed costs. Now that the replacement intention no longer exists, that part of the costs
can be disregarded (the expenses are incurred in the past and we have no reason to
reserve part of the profits for replacing the stand).

We are going to calculate in terms of cash flows; hence we only take into account the
revenues, the variable costs and the rent:

100
Qbep = = 200
(1.50 − 1)

If the prediction of selling 300 packages appears to be correct, then we will earn € 50.

Stated more generally, while calculating the Cash Break Even Point only variables are
taken into account that will generate future cash flows. The fixed costs usually contain
some cost items that relate to expenses in the past that will no longer occur in the
future when the business is discontinued (for instance depreciation) or relate to
expenses in the future that will no longer occur when the business is discontinued (for
instance a provision for maintenance). This, in essence, does not influence the

2
As well as the decision not to start a business at all.
formulation of the Cost Volume Profit model, because the changes relate to the
definition of the variables.

In a world where taxes do exist, however, a different situation exists, because in that
case the elimination of the replacement intention is not seen as a valid reason to stop
depreciating on assets (because it is a way to delay the payment of your taxes to the
future). In order to determine the Cash Break Even Point we place income (cash
inflows) opposite to expenses (cash outflows):

(1 − T ) * sp * Q = (1 − T ) * vc * Q − T * FC + FCF
[ (1 − T ) * ( sp − vc)] * Q = FCF − T * FC
FCF − T * FC
Qcbep =
[ (1 − T ) * ( sp − vc)]
in which:
QC bep = Cash Break Even Point
FCF = Future fixed expenses (Fixed Cash Flows).

Numerical example 5
For the last time we continue with the example of the fair. The selling price per packet of
stroopwafels amounts to € 1.50, the unit variable cost amounts to € 1.00. Depreciation
amounts to 100 per day that we stand on a fair and the rent of the stand place amounts to
€ 100.
As we have decided to discontinue our business, depreciation does not have to be taken
into account.
In a world without taxes the calculations would be a follows:

100
QC bep = = 200
(1.50 − 1.00)
This means that, when the actual sales have decreased below the 200 packages of
stroopwafels, the cash inflows are lower than the cash outflows. Therefore, this is not an
economically healthy situation.

If taxes on profit amount to 20%, the Cash Break Even point equals:

100 − 0.2 * 200

QC bep = = 150
(1 − 0.2) * (1.50 − 1.00)

This calculation can be verified as follows:

Revenues (cash inflows) 150 * € 1.50 € 225
Variable costs (cash outflows) 150 * € 1.00 - 150
Contribution margin € 75
Fixed costs - 200
Loss € 125
Tax repayment (cash inflows) 20% of € 125 € 25

In cash flows this means:

Revenues of sales € 225
Tax repayment - 25
Total cash inflows: € 250

Cash outflows for variable costs € 150

Cash outflows for rent (FCF) - 100
Total cash outflows: € 250