Chapter 3

Cost-Volume-Profit Analysis

Copyright 2003 Pearson Education Canada Inc. Slide 3-28

Cost-Volume-Profit Analysis
Examines the behaviour of total revenues, total costs,
and operating income as changes occur in the output
level, selling price, variable costs or fixed costs

Assumptions of CVP Analysis

1. revenues change in relation to production and sales
2. costs can be divided in variable and fixed categories
3. revenues and costs behave in a linear fashion
4. costs and prices are known
5. if more than one product exists, the sales mix is
constant
6. we can ignore the time value of money

Copyright 2003 Pearson Education Canada Inc. Page 67 Slide 3-29

Contribution Margin
Contribution margin is equal to the difference
between total revenue and total variable costs
Contribution margin per unit
= Selling price - Variable cost per unit
Contribution margin percentage
= Contribution margin per unit / selling price per unit
Total for
Per Unit 2 units %

Revenue $200 $400 100%

Variable costs 120 240 60%
Contribution margin $80 $160 40%
Copyright 2003 Pearson Education Canada Inc. Pages 68 - 69 Slide 3-30
 Contribution Margin Income Statement
Income statement that groups line items by cost
behaviour to highlight the contribution margin

Packages Sold
0 1 2 25 40

Revenue $0 $200 $400 $5,000 $8,000

Variable costs 0 120 240 3,000 4,800
Contribution margin 0 80 160 2,000 3,200
Fixed costs 2,000 2,000 2,000 2,000 2,000
Operating income $(2,000) $(1,920) $(1,840) $0 $1,200

Copyright 2003 Pearson Education Canada Inc. Page 69 Slide 3-31

 Breakeven Point
Quantity of output where total revenues equal total
costs
Point where operating income equals zero

Breakeven point in units

= Fixed costs / Contribution margin per unit
= $2,000 / $80
= 25 units

Breakeven point in dollars

= Fixed costs / contribution margin %
= $2,000 / 40%
= $5,000
Copyright 2003 Pearson Education Canada Inc. Page 71 Slide 3-32
Cost-Volume-Profit Graph

Total revenues
$10,000 Breakeven
line
Point
$8,000 25 units Total costs
line

$6,000
Operating
income
$4,000

$2,000
Operating
loss
$0
0 10 20 30 40 50
Units Sold

Copyright 2003 Pearson Education Canada Inc. Page 72 Slide 3-33

Target Operating Income

For most firms in the private sector, the main

objective is not to breakeven
Convert after-tax desired net income to its before-tax
equivalent operating income
Target operating income
= Target net income / (1 - tax rate)

Target Unit Sales

= (Fixed costs + Target operating income)
/ Contribution margin per unit
Target Dollar Sales
= (Fixed costs + Target operating income)
/ Contribution margin %
Copyright 2003 Pearson Education Canada Inc. Pages 73 - 75 Slide 3-34
Sensitivity Analysis

sensitivity analysis is a what-if technique that

examines how a result will change if the original
predicted data are not achieved or if an underlying
assumption changes
What will happen to operating income if volume
declines by 5%?
What will happen to operating income if variable
costs increase by 10% per unit?
sensitivity analysis broadens managements
perspectives about possible outcomes

Copyright 2003 Pearson Education Canada Inc. Pages 76 - 77 Slide 3-35

 Alternative Cost Structures

CVP helps managers assess the risks and potential

benefits of adopting alternative cost structures
Example: Alternative rental arrangements
Option 2
Option 1 $1,400 Fixed Fee Option 3
$2,000 Fixed Fee + 5% Commission 20% Commission
Rev Rev Rev
$ $ $
Cost Cost Cost

Units Units Units

Breakeven = 25 units Breakeven = 20 units Breakeven = 0 units

Copyright 2003 Pearson Education Canada Inc. Pages 77 - 78 Slide 3-36

 Revenue Mix

Revenue mix (or sales mix) is the relative

combination of quantities of products or services
that make up total revenue

Do-All Do-All Superword

Sales mix of Do-All : Superword = 2 : 1

Breakeven point in units

= 30 units 20 units of Do-All
10 units of Superword

Copyright 2003 Pearson Education Canada Inc. Pages 73 - 75 Slide 3-37

Multiple Cost Drivers

In many cases there may be multiple cost drivers

Do-All Software Example

Variable costs: $40 per software package sold
$15 per invoice issued
Operating income
= Revenue ($40 x packages sold) ($15 x invoices
issued) Fixed costs

In cases where there are multiple cost drivers there

are multiple breakeven points

Copyright 2003 Pearson Education Canada Inc. Pages 81 - 82 Slide 3-38

 Contribution Margin & Gross Margin

Merchandising Sector

Contribution Margin Gross Margin

Format Format

Revenues $200 Revenues $200

Variable costs:
Cost of goods sold (120+5) 125
Cost of goods sold $120
Other variable 43 163 Gross margin 75
Contribution margin 37 Operating costs (43+19) 62
Fixed costs:
Cost of goods sold 5 Operating income $13
Other fixed 19 24
Operating income $13

Copyright 2003 Pearson Education Canada Inc. Pages 82 - 83 Slide 3-39

 Contribution Margin & Gross Margin

Manufacturing Sector

Contribution Margin Gross Margin

Format Format

Revenues $1,000 Revenues $1,000

Variable costs:
Cost of goods sold (250+160) 410
Manufacturing $250
Non-manufacturing 270 520 Gross margin 590
Contribution margin 480 Non-manufacturing (270+138) 408
Fixed costs:
Manufacturing 160 Operating income $182
Non-manufacturing 138 298
Operating income $182

Copyright 2003 Pearson Education Canada Inc. Pages 81 - 82 Slide 3-40

Decision Models and Uncertainty

Managers make predictions and decisions in a world

of uncertainty
Estimate events that are likely to occur and assign
probabilities to each outcome
Probability distribution describes the likelihood of
each mutually exclusive and collectively exhaustive
set of events (must add to 1.00)
Expected value is a weighted average of the
outcomes with the probability of each outcome
serving as the weight

Copyright 2003 Pearson Education Canada Inc. Pages 86 - 87 Slide 3-41

Uncertainty Example

0.5
Probability 0.4
Proposal A: 0.3
Spy Novel 0.2
0.1

1 2 3 4 5 6 7 8 9
Cash Inflow ($000,000)

Expected value
= (0.1*$300,000) + (.02*$350,000) + (.04*$400,000) +
(0.2*$450,000) + (0.1*$500,000)
= $400,000
Copyright 2003 Pearson Education Canada Inc. Page 87 Slide 3-42