CHAPTER 2: COST-VOLUME-

PROFIT ANALYSIS
1
INTRODUCTION
Today we will focus on gaining an
understanding of how . . .
 Costs
 Volume, and
 Profits
Interact

2
LECTURE OUTLINE
 Cost behavior
 Cost-Volume-Profit (CVP)analysis
 Contribution margin and its measures
 Break-event point analysis
 Computing sales for target income
 Multiple-product analysis
 With risk and uncertainty
 Assumptions in CVP analysis
 Using sensitivity analysis
 Ethical consideration

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IMPORTANT OF COST BEHAVIOR IN
BUSINESS
 Understanding cost behavior help
managers to:

 Predict future conditions (planning);

and

 Explain, evaluate, and act on past

results (control)

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COST BEHAVIOR
 Cost behavior is the way a cost changes
when the level of output changes.
 Cost behavior patterns:

 Fixed costs
 Variable costs
 Mixed costs (Semi-variable costs)
 Step costs (Step-fixed costs)

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FIXED AND VARIABLE COSTS
 Fixed costs
 Remains unchanged in total within a relevant
range as the level of output varies
 As activity increases, total fixed costs do not
change, but unit fixed cost declines
 Variable costs
 Change in total in direct proportion to a change in
output
 As activity increases, total variable costs increase,
but unit variable cost do not change
Notes: The relevant range is the limit of output level within which
a specific relationship between costs and the cost driver is
valid.
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 FIXED COSTS & RELEVANT RANGE

Example: Office space

is available at a rental
rate of $30,000 per year
in increments of 1,000
square feet. As the
business grows more
space is rented,
increasing the total
cost.
Cotinue
 VARIABLE COST
FIXED AND VARIABLE COSTS: EXAMPLES
Numbers of units Cost per Unit Total costs

1 $30 $30
10 $30 $300
100 $30 $3,000
200 $30 $6,000

Numbers of units Monthly cost Cost per unit

1 $9,000 $9,000
10 $9,000 $900
100 $9,000 $90
200 $9,000 $45 8

FIXED COST
 FIXED AND VARIABLE COSTS

$
$

Volume Volume

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MIXED COSTS (SEMI-VARIABLE COSTS)
 Mixed cost includes both fixed and variable cost
components (compensation for sales
representatives)
 The formula for mixed costs is:
Total cost = total fixed cost + total variable cost
Y = a + bX

Where Y = total cost

a = fixed cost component (the intercept on the vertical axis)
b = variable cost per unit of activity (the slope of the line)
X = the level of activity

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MIXED-COSTS
Linearity Assumption
Total Costs
$

Fixed Costs
Variable
Costs

Volume

Total cost = Fixed cost + Total variable cost

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STEP-FIXED COSTS (STEP COSTS)
 A step cost displays a constant level of cost for a
range of output and then jumps to a higher level
of cost at some point, where it remains for a
similar range of output.
 The width of step defines the range of output for
which a particular amount of the resource
applies.
 Many so-called fixed costs may be, in reality, step
costs.

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STEP-FIXED COSTS (STEP COSTS)

Step Costs are constant within

a range of activity.

But different
between ranges
of activity
13
Volume
SEPARATING MIXED COSTS
 Why we need to separate mixed costs into fixed
and variable components?
 Accounting records typically show the total costs and
the associated amount of output of a mixed cost item.
 E.g. the total cost of maintenance and the number of
maintenance hours provided during a given period of
time.
 Methods for Separating Mixed Costs
 The High-Low Method
 The Scatterplot Method
 The Method of Least Squares 14
SEPARATING MIXED COSTS
 A scatter plot can be useful in allowing us to plot the
data points to visualise the relationship between cost
and the level of output
 The high-low method involves taking the two
observations with the highest and lowest level of
output to calculate the cost function
 Regression analysis is a statistical technique that
uses all observations to determine the cost function

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COST VOLUME PROFIT (CVP) ANALYSIS
 A technique used to determine the effects of
changes in an organisation’s sales volume on its
costs, revenue and profit
 Can be used in profit-seeking and not-for profit
organisations

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 INCOME STATEMENTS . . .
Traditional Contribution Format

Sales $xxx Sales $xxx

COGS (xx) Variable Costs (xx)
Gross Margin $xxx Cont. Margin $xxx
Operating Exp (xx) Fixed Costs (xx)
Net Income $xxx Net Income $xxx

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CONTRIBUTION MARGIN AND ITS
MEASURES

 Contribution margin (or variable costing)

statement
 A reporting format where costs are reported by cost
behaviour and a contribution margin is calculated
 Total contribution margin
 The difference between the sales revenue and the
variable costs
 The amount available to cover fixed costs and then
contribute to profits

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CONTRIBUTION MARGIN AND ITS
MEASURES

 Unit contribution margin

 The difference between the sales price per unit and
variable cost per unit
 Contribution margin ratio
 The unit contribution margin divided by the unit
sales price
 The proportion of each sales dollar available to cover
fixed costs and earn a profit

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THE CONTRIBUTION APPROACH
For each additional unit Wind sells, $200
more in contribution margin will help to
cover fixed expenses and profit.

Total Per Unit Perc

Sales (500 bikes) $ 250,000 $ 500 1
Less: variable expenses 150,000 300
Contribution margin $ 100,000 $ 200
Less: fixed expenses 80,000
Net income $ 20,000

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THE CONTRIBUTION APPROACH

Each month Wind must generate at least

$80,000 in total CM to break even.

Total Per Unit Perc

Sales (500 bikes) $ 250,000 $ 500 1
Less: variable expenses 150,000 300
Contribution margin $ 100,000 $ 200
Less: fixed expenses 80,000
Net income $ 20,000
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THE CONTRIBUTION APPROACH

If Wind sells 400 units in a month, it will be

operating at the break-even point.
WIND BICYCLE CO.
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (400 bikes) $ 200,000 $ 500
Less: variable expenses 120,000 300
Contribution margin 80,000 $ 200
Less: fixed expenses 80,000
Net income $ 0
22
THE CONTRIBUTION APPROACH
If Wind sells one additional unit (401
bikes), net income will increase by $200.
WIND BICYCLE CO.
Contribution Income Statement
For the Month of June
Total Per Unit
Sales (401 bikes) $ 200,500 $ 500
Less: variable expenses 120,300 300
Contribution margin 80,200 $ 200
Less: fixed expenses 80,000
Net income $ 200
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THE BREAK-EVEN POINT (BEP)
 The volume of sales where the total revenues and
expenses are equal, and the operation breaks
even
 Can be calculated for an entire organisation or
individual projects or activities
 3 methods to identify the break-event point
 Equation method: Total sales revenues = Total costs
Total sales = Total variable costs + total fixed costs
 Contribution margin method
 CVP graph

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BEP: CONTRIBUTION MARGIN METHOD
The contribution margin method is a variation of the
equation method.

Break-even point Fixed costs

=
in units sold Unit contribution margin

Break-even point in Fixed costs

total sales dollars =
CM ratio

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BEP: COST VOLUME PROFIT (CVP) GRAPH
 Shows how costs, revenue and profits change as
sales volume changes
 Four steps
1. Draw the fixed expense line
2. Draw the total expense line
3. Draw the total revenue line
4. Break-even point—where the total revenue and
total expense lines intersect

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CVP GRAPH
450,000

400,000

350,000

300,000
Total Expenses
250,000

200,000

150,000 Fixed expenses

100,000

50,000

-
- 100 200 300 400 500 600 700 800
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Units
CVP GRAPH
450,000

400,000

350,000

300,000
Total Sales
250,000

200,000

150,000

100,000

50,000

-
- 100 200 300 400 500 600 700 800 28
Units
CVP GRAPH
450,000

400,000

350,000

300,000

250,000

200,000

150,000
Break-even point
100,000

50,000

-
- 100 200 300 400 500 600 700 800

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Units
UNITS & SALES NEEDED TO ACHIEVE A
TARGET INCOME

 A target income: A desired profit level before tax

determined by management
 Can be used within the break-even formula

Fixed costs + target income

Target sales volume =
Unit contribution margin

Fixed costs + target income

Target sales =
Contribution margin ratio

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 INCLUDING INCOME TAXES

Sales volume required to earn target after - tax income

target net income after tax
Fixed costs +
(1 - t)
=
Unit contribution margin

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CVP ANALYSIS & RISK AND CERTAINTY:
SAFETY MARGIN
 Gives a feel for how close projected operations are
to the break-even point.
 There are 3 measures: in dollars, in percentage
and in units

Safety margin in dollars = Budgeted sales –

Break-even sales

Safety margin in units = Budgeted sales units –

Break-even units
Safety percentage = Safety in dollars/Total sales
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THE MARGIN OF SAFETY IN DOLLARS
The margin of safety in dollars is the excess of
budgeted (or actual) sales over the break-even
volume of sales.

Margin of safety in dollars = Total sales - Break-

even sales

Let’s look at Racing Bicycle Company and determine the

margin of safety.
 THE MARGIN OF SAFETY IN
DOLLARS
If we assume that RBC has actual sales of $250,000, given
that we have already determined the break-even sales to
be $200,000, the margin of safety is $50,000 as shown.

Break-even
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income $ - $ 20,000
THE MARGIN OF SAFETY
PERCENTAGE
RBC’s margin of safety can be expressed as 20% of
sales. ($50,000 ÷ $250,000)

Break-even
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income $ - $ 20,000
THE MARGIN OF SAFETY IN UNITS
The margin of safety can be expressed in terms of the
number of units sold. The margin of safety at RBC is
$50,000, and each bike sells for $500; hence, RBC’s
margin of safety is 100 bikes.

Margin of $50,000
= = 100 bikes
Safety in units $500
CVP ANALYSIS: OPERATING LEVERAGE
 Operating leverage is the use of fixed costs to
multiple the impact of sales changes on income.
 Degree of operating leverage (DOL) for a given level of sales

DOL= Contribution margin / Operating income

Percentage change in operating income =

DOL x percentage change in sales

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 OPERATING LEVERAGE
Operating leverage is a measure of how sensitive
net operating income is to percentage changes in
sales. It is a measure, at any given level of sales, of
how a percentage change in sales volume will
affect profits.
Contributi on Margin
DOL Degree of Operating Leverage 
Net Operating Income * *

** Profit Before Tax is a commonly used alternative to Net

Operating Income in the degree of operating leverage
calculation
OPERATING LEVERAGE
To illustrate, let’s revisit the contribution
income statement for RBC.
Actual sales
500 Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income $ 20,000

Degree of
Operating = $100,000 = 5
Leverage $20,000
OPERATING LEVERAGE
With an operating leverage of 5, if RBC increases its sales by
10%, net operating income would increase by 50%.

Percent increase in sales 10%

Degree of operating leverage × 5
Percent increase in profits 50%

Here’s the verification!

OPERATING LEVERAGE
Actual sales Increased
(500) sales (550)
Sales $ 250,000 $ 275,000
Less variable expenses 150,000 165,000
Contribution margin 100,000 110,000
Less fixed expenses 80,000 80,000
Net operating income $ 20,000 $ 30,000

10% increase in sales from

$250,000 to $275,000 . . .

. . . results in a 50% increase in

income from $20,000 to $30,000.
WHAT DOES HIGHER VALUE OF
OPERATING LEVERAGE MEAN?

 High Operating Leverage ratio

 signals the existence of high fixed costs.
 increases risk of making loss in adverse market conditions.

 increases opportunity to make profit when higher demand exists.

 has lower margin of safety percentage (MoS%)

1
DOL
MoS%
CVP ANALYSIS WITH MULTIPLE PRODUCTS
 Sales mix
 The relative proportions of each type of product
(units) sold by the organisation
 Package unit contribution margin
 The unit contribution margins of a package in
according with sales mix

Fixed costs
Break - even package =
Package unit contribution margin

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THE CONCEPT OF SALES MIX
Sales mix is the relative proportion in which a
company’s products are sold.
Different products have different selling prices, cost
structures, and contribution margins.
When a company sells more than one product,
break-even analysis becomes more complex as
the following example illustrates.

Let’s assume Racing Bicycle Company sells bikes and

carts and that the sales mix between the two
products remains the same.
 MULTI-PRODUCT BREAKEVEN ANALYSIS
(THE BE% METHOD)
RBC’s Bikes and Carts sales and profit data are as
Bicycle follows:
Carts Total
Sales $ 250,000 $ 300,000 $ 550,000
Variable expenses 150,000 135,000 285,000
Contribution margin 100,000 165,000 265,000
Fixed expenses 170,000
Net operating income $ 95,000

Sales $ 250,000
$300,000 x Contributi on Margin 1
DOL  
BE% = Net Operating Income MoS%
64.15% Net Operating Income
 MoS% 
Breakeven sales $160,375 Contributi on Margin
$192,450 95,000
Total breakeven sales =  MoS%   35.85%
265,000
$352,825
 MoS%  1  BE%
 BE%  1  MoS%  1  35.85  64.15%
 MULTI-PRODUCT BREAKEVEN ANALYSIS
(THE BE% METHOD)
Bicycle Carts Total
160,37 100 192,45 100 100.0
Sales 5 % 0 % 352,825 %

Variable expenses 96,225 60% 86,603 45% 182,828 51.8%

Contribution 105,84
margin 64,150 40% 7 55% 169,997 48.2%

Fixed expenses 170,000

Rounding
Net operating income error (3)
 MULTI-PRODUCT BREAKEVEN ANALYSIS
(THE CM RATIO METHOD)
Bikes comprise 45% of RBC’s total sales revenue
and the carts comprise the remaining 55%.
RBC provides the following information:
Bicycle Carts Total
Sales $ 250,000 100% $ 300,000 100% $ 550,000 100.0%
Variable expenses 150,000 60% 135,000 45% 285,000 51.8%
Contribution margin 100,000 40.0% 165,000 55% 265,000 48.2%
Fixed expenses 170,000
Net operating income $ 95,000

Sales mix $ 250,000 45% $ 300,000 55% $ 550,000 100%

$265,000= 48.2% (rounde

$550,000
 MULTI-PRODUCT BREAKEVEN ANALYSIS
(THE CM RATIO METHOD)
Dollar sales to Fixed expenses
=
break even CM ratio

Dollar sales to $170,000

= = $352,697
break even 48.2%

Bicycle Carts Total

Sales $ 158,714 100% $ 193,983 100% $ 352,697 100.0%
Variable expenses 95,228 60% 87,293 45% 182,521 51.8%
Contribution margin 63,485 40% 106,691 55% 170,176 48.2%
Fixed expenses 170,000
Net operating income Rounding error $ 176

Sales Mix $ 158,714 45% $ 193,983 55% $ 352,697 100.0%

CVP ANALYSIS AND LONG-TERM
DECISIONS

 CVP analysis is usually regarded a short-term or

tactical decision tool
 Classification of costs as variable or fixed is
usually based on cost behaviour over the short-
term
 The financial impact of long-term decisions best
analysed using capital budgeting techniques

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TREATING CVP ANALYSIS WITH CAUTION
 CVP analysis is merely a simplified model
 The usefulness of CVP analysis may be greater in
less complex smaller firms, or stand-alone
projects
 For larger firms, CVP analysis can be valuable as
a decision tool for the planning stages of new
projects and ventures

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KEY ASSUMPTIONS OF CVP
ANALYSIS
 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).
 Practical example – CVP Analysis
XYZ Airlines runs 35 scheduled round-trip flights
each week between Hanoi and HCM City. It charges a
fixed one-way fare of $200 per passenger. XYZ
Airlines can carry 150 passengers per one-way flight.
Fuel and other flight-related costs are $5,000 per
one-way flight. On-flight meal and refreshment costs
average $5 per passenger. Flight crew, ground crew,
advertising, and other administrative expenditures
for the Hanoi–to–HCM City route amount to
$400,000 each week.
Required:
1. How many passengers must each of the 70 one-way flights
have on average to break even each week?
2. If the load factor is 60% on all flights (that is, the flights are
60% full), how many flights per week must XYZ Airlines
operate on this route to earn a total weekly profit of
$500,000 after taxes given the cooperate income tax rate is
25%?
SENSITIVITY ANALYSIS AND CVP ANALYSIS
 Sensitivity analysis
 An approach which examines how an outcome may
change due to variations in the predicted data or
underlying assumptions
 Can be run using spreadsheet software, such as
Excel

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CVP ANALYSIS AND MANAGERIAL ETHICS

Ethical judgment
 Make sure to have the best
information possible when making
decisions
 Not let personal factors affect the use
of cost information

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