Cost-Volume-Profit Analysis : A Managerial Planning Tool

Cost-volume-profit analysis (CVP analysis) is a powerful tool for planning and decision
making. Because CVP analysis emphasizes the interrelationships of costs, quantity sold, and
price, it brings together all of the financial information of the firm. CVP analysis can be a
valuable tool to identify the extent and magnitude of the economic trouble a division is facing
and to help pinpoint the necessary solution.
1. Break-Even Point in Units
The break-even point is the point where total revenue equals total cost, the point of zero profit.
The firm’s initial decision in implementing a units-sold approach to CVP analysis is the
determination of just what a unit is. A second decision centers on the separation of costs into
fixed and variable components.
Using Operating Income in CVP Analysis
The income statement is a useful tool for organizing the firm’s costs into fixed and variable
categories. The income statement can be expressed as a narrative equation:
Operating income = Sales revenues - Variable expenses - Fixed expenses
Note that we are using the term operating income to denote income or profit before income
taxes. Operating income includes only revenues and expenses from the firm’s normal
operations. Net income is operating income minus income taxes. Once we have a measure of
units sold, we can expand the operating-income equation by expressing sales revenues and
variable expenses in terms of unit dollar amounts and number of units. With these expressions,
the operating-income equation becomes:
Operating income = (Price x Number of units sold) - (Variable cost per unit x Number of units
sold) - Total fixed cost
An important advantage of the operating-income approach is that all further CVP equations
are derived from the variable-costing income statement. As a result, you can solve any CVP
problem by using this approach.
Shortcut to Calculating Break-Even Units
The contribution margin is sales revenue minus total variable cost. At breakeven, the
contribution margin equals the fixed expenses. If we substitute the unit contribution margin for
price minus unit variable cost in the operating-income equation and solve for the number of units,
we obtain the following fundamental break-even equation:
Number of units = Fixed cost/Unit contribution margin
Unit Sales Needed to Achieve Targeted Profit
While the break-even point is useful information, most firms would like to earn operating
income greater than zero. CVP analysis gives us a way to determine how many units must be sold
to earn a particular targeted income. Targeted operating income can be expressed as a dollar
amount (for example, $20,000) or as a percentage of sales revenue (for example, 15 percent of
revenue). Both the operating-income approach and the contribution margin approach can be
easily adjusted to allow for targeted income.
2. Calculate the amount of revenue required to break even or to earn a targeted profit.
 Break-even revenue is computed by dividing the total fixed costs by the contribution margin
ratio. Targeted profit is added to fixed costs in determining the amount of revenue needed to yield
the targeted profit.
3. Apply cost-volume-profit analysis in a multiple-product setting.
Cost-volume-profit analysis is fairly simple in the single-product setting. However, most firms
produce and sell a number of products or services. Even though the conceptual complexity of
CVP analysis does increase with multiple products, the operation is reasonably straightforward.
A break-even product margin covers only direct fixed costs; the common fixed costs remain to
be covered. No break-even point for the firm as a whole has yet been identified. Somehow, the
common fixed costs must be factored into the analysis. Allocating the common fixed costs to
each product line before computing a break-even point may resolve this difficulty. The problem
with this approach is that allocation of the common fixed costs is arbitrary. Thus, no meaningful
break-even volume is readily apparent.
Another possible solution is to convert the multiple-product problem into a single-product
problem. If this can be done, then all of the single-product CVP methodology can be applied
directly. The key to this conversion is to identify the expected sales mix, in units, of the products
being marketed. Sales mix is the relative combination of products being sold by a firm. However,
it should be remembered that the answers change as the sales mix changes. If the sales mix
changes in a multiple-product firm, the breakeven point will also change. In general, increases in
the sales of high contribution margin products will decrease the break-even point, while increases
in the sales of low contribution margin products will increase the break-even point.
4. Prepare a profit-volume graph & a cost-volume-profit graph, & explain the meaning of
each.
CVP is based on several assumptions that must be considered in applying it to business
problems. The analysis assumes linear revenue and cost functions, no finished goods ending
inventories, and a constant sales mix. CVP analysis also assumes that selling prices and fixed and
variable costs are known with certainty. These assumptions form the basis for simple graphical
analysis using the profit-volume graph and the cost-volume-profit graph.
The Profit-Volume Graph
A profit-volume graph visually portrays the relationship between profits and sales volume.
The profit-volume graph is the graph of the operating-income equation
Operating income = (Price x Units) - (Unit variable cost x Units) - Fixed cost
In this graph, operating income is the dependent variable, and units is the independent
variable. Usually, values of the independent variable are measured along the horizontal axis and
values of the dependent variable along the vertical axis.
The Cost-Volume-Profit Graph
The cost-volume-profit graph depicts the relationships among cost, volume, and profits. To
obtain the more detailed relationships, it is necessary to graph two separate lines: the total
revenue line and the total cost line. These two lines are represented, respectively, by the
following two equations:
Revenue = Price x Units
Total cost = (Unit variable cost x Units) + Fixed cost
5. Explain the impact of risk, uncertainty, and changing variables on cost-volume-profit
analysis.
Measures of risk and uncertainty, such as the margin of safety and operating leverage, can be
used to give managers more insight into CVP answers. Sensitivity analysis gives still more
insight into the effect of changes in underlying variables on CVP relationships.
Introducing Risk and Uncertainty
An important assumption of CVP analysis is that prices and costs are known with certainty.
Risk and uncertainty are a part of business decision making and must be dealt with somehow.
How do managers deal with risk and uncertainty? A variety of methods can be used. First, of
course, management must realize the uncertain nature of future prices, costs, and quantities. Next,
managers move from consideration of a break-even point to what might be called a “break-even
band.” Further, managers may engage in sensitivity or what-if analysis. In this instance, a
computer spreadsheet is helpful, as managers set up the break-even (or targeted profit)
relationships and then check to see the impact that varying costs and prices have on quantity sold.
Two concepts useful to management are margin of safety and operating leverage. Both of these
may be considered measures of risk. Each requires knowledge of fixed and variable costs.
The margin of safety is the units sold or expected to be sold or the revenue earned or
expected to be earned above the break-even volume. Operating leverage is the use of fixed costs
to extract higher percentage changes in profits as sales activity changes.
Sensitivity Analysis and CVP
The pervasiveness of personal computers and
spreadsheets has placed sensitivity analysis within reach of
most managers. An important tool, sensitivity analysis is a
“what if” technique that examines the impact of changes in
underlying assumptions on an answer. It is relatively
simple to input data on prices, variable costs, fixed costs,
and sales mix and to set up formulas to calculate break-even points and expected profits. Then,
the data can be varied as desired to see how changes impact the expected profit.
6. Discuss the impact of activity-based
costing on cost-volume-profit analysis.
CVP can be used with activity-based costing, but
the analysis must be modified. In effect, under
ABC, a type of sensitivity analysis is used. Fixed
costs are separated from a variety of costs that
vary with particular cost drivers. At this stage, it
is easiest to organize variable costs as unit-level,
batch-level, and product-level. Then, the impact
of decisions on batches and products can be
examined within the CVP framework. The
subject of cost-volume-profit analysis naturally
lends itself to the use of numerous equations.