CVP ANALYSIS AND BREAK-EVEN ANALYSIS

- The study of the effects on future profit of changes in SINGLE PRODUCTS

fixed cost, variable cost, sales price, quantity and mix (CIMA)

Assumptions in CVP Analysis (adapted from CMA, CIMA):

1) All costs are either variable or fixed costs
2) Variable Costing is used
3) Total costs and total revenues are predictable and linear PART 1 COST BEHAVIOR
4) The following remain constant over the relevant range: Overview
a) Fixed Costs in total ▪ Sometimes known as Breakeven analysis, Cost-Volume-Profit (CVP)
b) Variable Costs per unit analysis is a classic, and very effective, tool for understanding and
c) Selling Price per unit managing the relationship between costs, prices, sale volumes, and
d) Sales Mix profits.
5) Finished Goods and Work-in-Process Inventories do not change
significantly The “One” Cost-Volume-Profit Formula and Its Formats
6) All units produced are sold a. The Cost-Volume-Profit (C-V-P) formula is effectively the formula for profit
7) Volume is the only cost driver. Inflation is ignored. in the organization.
8) The time value of money is ignored. Basic CVP Formula Revenue – Variable Cost – Fixed Cost = Profit
Expanded Format (1) (SP x Volume) – (VC per unit x Volume) – FC = Profit
Benefits of CVP Analysis Expanded Format (2) Revenue – (VC Ratio* x Revenue) – FC = Profit
1) Helps managers understand interrelationships among cost, volume and *VC Ratio = VC ÷ Revenue
profit
2) Useful in many business decisions such as: Cost-Volume-Profit Charts and Explanation
a) Deciding what products to manufacture or sell - Visually show the relationship of revenue and costs across the volume
b) What pricing policy to follow of the key production activity.
c) What marketing strategy to employ 1) Variable costs per unit of activity are depicted in the C-V-P chart as the
d) What type of productive facilities to acquire slope (rise over run) of the Total Costs line.
2) Fixed costs can certainly shift and change based on many different
3 Ways to Perform CVP Analysis circumstances, but fixed costs are constant with respect to the volume of the
1) The Contribution Format Income Statement key production activity and should always be stated in total.
2) Charts and Graphs 3) Breakeven is defined as the level of sales and activity volume at which
3) Algebraic or Mathematical Formula revenues exactly offset total costs, both fixed and variable. This is the point in
the C-V-P chart where the Revenue line crosses over the Total Costs line.
The Contribution Format Income Statement 4) The breakeven point usually can be expressed both in sales units (on the
Sales/Revenue XX horizontal axis in the C-V-P chart) and in sales dollars (on the vertical axis in
Variable Costs (XX) the C-V-P chart).
Contribution Margin XX 5) Profit and loss is defined by the difference between revenue and total cost
Fixed Costs (XX) above and below the breakeven point, respectively.
Operating Income XX
Cost Behavior
The Basic Break-even Chart (source: CIMA) - Cost behavior is based on the organization's key activity
- The key activity is what primarily drives costs and revenues and can be
defined as almost anything for any organization (items sold for a retail
store, feet drilled for an oil driller, billable hours for a law firm, etc.)

Summary
• Profit analysis in an organization is effectively evaluated with the
Cost-Volume-Profit (C-V-P) formula.
• The basic formula of Revenue – Variable Cost = Contribution
Margin – Fixed Cost = Profit can be used to derive breakeven as
well as expanded into two other formats.
• Cost-Volume-Profit charts are used to visually show the
relationship of revenue and costs.
• Cost behavior in any organization is based on the key activity of
The Contribution Break-even Chart (source: CIMA) that organization. (billable hours in law firms, etc.)
• The key activity is any factor that primarily drives costs and
revenues.

The Profit-Volume Chart (source: CIMA)

PART 2 CONTRIBUTION MARGIN Effect of Timeframe on the Classification of Fixed and Variable Costs
Overview 1) The C-V-P formula and the contribution margin approach to managing profit
▪ Another critical tool used by management to evaluate revenues and are based very much on the assumption that the variable cost per unit and the
costs is contribution margin. total fixed costs remain constant.
▪ Unlike gross margin, contribution margin focuses on the effects of 2) As different levels of production volume activity in the analysis, these two
fixed and variable costs on operating profit. numbers won't shift.
3) The upper and lower boundary of production volume activity where variable
The Contribution Margin Statement (source: Wiley) cost per unit or total fixed costs start to change represents the relevant range
of the management analysis.

Relevant Range
- is a key assumption in C-V-P analysis
- as a business expands or contracts, variable costs per unit or total fixed
costs will shift
- when this happens, the current relevant range of production activity shifts,
and must reanalyze costs to identify the new variable cost per unit and/or the
GAAP & IFRS I/S CONT. MARGIN I/S new total fixed costs.
OP. COSTS > Cost of Goods Sold; > Variable Costs - at that point, we use the new data for the C-V-P formula and the contribution
CLASSIFICATION > Admin. & Sales Expense > Fixed Costs margin approach.
useful for tracking product useful for effective
USE costs through inventory on management of profit Other Terms:
the balance sheet ✓ Mixed Costs (or Total Costs) – possess both fixed and variable
Note: either type of I/S reports on the same overall OPEX, but classifying costs using
components where y is total cost; a is total fixed cost; b is variable
different criteria. The CM approach is focused on cost behavior.
cost per unit, hr, etc; x is number of units, hours, etc.
In EQUATION FORM:
The Contribution Margin Income Statement
- Also called Variable Costing Income Statement or o Fixed Cost → y=a
- Marginal Income Statement or o Variable Cost → y = bx
- Direct Costing Income Statement o Mixed Cost → y = a + bx
✓ Semivariable Costs
– unlike in purely variable costs, the rate of change in these cost
items with the change in activity (or volume) level is not constant
o instead of increasing at a constant rate, these costs tend to:
> either increase at an increasing rate or
> increase at a decreasing rate
✓ Semifixed Costs
(source: Wiley) – also called “step function costs” or “step costs” and possess
- It is useful to break down revenue, variable costs, and contribution some characteristics of both variable and fixed costs
margin to unit values (i.e., price per unit, variable cost per unit, – Like Variable Costs, these costs increase with the activity level
contribution margin per unit). (although not proportionately)
- Caution: fixed costs and operating profit must not be reduced to unit – Like Fixed Costs, these costs remain constant for stretches of
values (because these two numbers do not remain constant with activity levels (although not for all levels of activity)
increases and decreases in sales volume) ✓ High-Low Method
→ See Summary on Characteristics of Variable and Fixed Costs below – a simple technique of segregating mixed costs components
Steps:
Characteristics of Variable and Fixed Costs 1) Choose the representative highest and lowest activity levels with
TOTAL COST COST PER UNIT their corresponding costs
Variable Costs Changes proportionately* Constant 2) Get the differences (or changes) between the highest and lowest
y=a to changes in volume cost and activity levels. These differences represent the change in
Fixed Costs Constant Changes inversely** to cost with the change in activity levels
y = bx changes in volume 3) Determine the rate of cost variability with activity level
for example:
- Variable Costs are best measured and managed in their unit amount Variable Rate/unit or (b) = Diff. in Cost ÷ Diff. in Activity Level
- Fixed Costs are best measured or managed in their total amount 4) Determine the total amount of fixed cost (a)
- both the highest and lowest activity levels are used in the
Contribution Margin computations
- represents the portion of revenues that are available to cover fixed costs. - on both activity levels, fixed costs remained constant
- expressed on a per-unit basis or as a ratio (percentage) of revenue Note: y is total cost; a is total fixed cost; b is variable cost per unit,
hr, etc; x is number of units, hours, etc
a = y – bX

Summary
• Contribution margin is computed as Revenue – Variable Costs.
- Contribution margin calculations can be used to provide an easy way to • On the other hand, gross margin is computed as Revenue – Cost of
shorten the C-V-P formula Goods Sold.
• It is crucial to understand the difference between contribution
margin and gross margin.
• Contribution margin is used in management accounting analysis to
quickly determine the effects of prices, costs, and volumes of
Computing Income at Different Levels of Operating Volume activity on Operating Profit.
- many ways to compute income with varying levels of op. volume; • It is important to note that cost structures (and prices) are only
- the most efficient approach is based on contribution margin numbers constant within a relevant range of time or activity. When
operations move outside the relevant range of activity, the
Calculating Breakeven with the Simplified C-V-P Formula contribution margin analysis needs to be reset.
Break-even Point Break-even Point (Sales
(Units) Calculation Dollars) Calculation
Unit Information is BEP in Sales Dollars BEP in units x SP per unit
available SP per unit

Unit info is not Total Fixed Costs Total Fixed Costs

available but has CM Rate* CM Ratio**
Total Sales, VC, FC *SP per unit – VC per unit **CM ÷ Sales Revenue
PART 3 TARGETED PROFIT AND TAXES → The sales mix is the sales of each product or service relative to total sales.
Overview → It is critical to use the sales mix ratio consistently when solving C-V-P
▪ Most companies are not as interested in just breaking even as they are problems.
in achieving a particular after-tax income goal (often referred to as 3) Remember that the sales mix is about how all the products’ sales relate to
targeted profit). each other.
4) Caution: Don't use the products’ costs or profits in determining the sales
Targeted Profit and the Basic C-V-P Formula mix. This is a common mistake.
- Generally, organizations are much more interested in understanding 5) The sales mix can be computed either in terms of sales volume (units) or in
how to achieve a certain level of profit versus achieving zero profit (i.e., terms of sales revenue (dollars).
breakeven). 6) The sales mix ratio will be different when computed in units versus dollars.
7) Either type of sales mix ratio (units or dollars) can be used in the C-V-P
- In this case, rather than using the C-V-P formula to do breakeven formula, but it is crucial that one or the other sales mix ratio is used
analysis, we instead use the formula to do Targeted Profit Analysis consistently throughout the analysis. Don't mix them up!

- No adjustment to the basic C-V-P formula to incorporate targeted profit. C-V-P Computations with Multiple Products
1) Once organization's sales mix is determined, then do C-V-P analysis.
- Instead of setting Profit = $0 to do breakeven analysis, now set (i.e.,
target) the Profit at whatever amount is desired, and solve the formula 2) If no data on unit prices and unit variable costs, or if want to do breakeven
or targeted profit analyses on the organization's sales revenue, use the
- Sometimes this is referred to as “What-If” analysis. For example: variable cost ratio format of the C-V-P formula.
WHAT IF we wanted a target profit at $10,000?
a) What would Volume need to be? Or
b) what would Sales Price need to be? Or 3) Alternatively, if there’s data on unit prices and unit variable costs, then use
c) what would Variable Cost per Unit (or Total Fixed Costs) need to be? the more traditional unit-based format of the C-V-P formula.

Simplified Formula →
Adjusting the C-V-P Formula for Income Taxes
- all the Revenue, Cost, and Profit factors in the C-V-P are in pre-tax 4) Use the sales mix for revenue (not the sales mix for units)
dollars. → When solving for breakeven or targeted profit revenue using the variable
- Caution: When income taxes are involved and the difference between cost ratio format of the C-V-P formula
pre-tax operating profit and after-tax profit → The easiest version of the sales mix is the ratio of percentages
- If the targeted profit is defined as an after-tax profit, then you need to
convert after-tax profit to pre-tax profit before you run any C-V-P 5) Use the sales mix for volume of units (not the sales mix for revenue dollars)
analyses. The conversion formula is: → When solving for breakeven or targeted profit volume using the more
traditional unit-based format of the C-V-P formula
→ And the easiest way to approach this multiproduct C-V-P analysis is using
the “basket method.”
After-tax Profit Formula
The “basket method” is a three-step process:
1. Make a basket with the sales mix.
2. Solve the C-V-P for the basket.
3. Multiply the basket solution with the sales mix.

Crucial C-V-P Assumptions

a) Assume a constant sales mix in calculating C-V-P analysis.
→The sales mix is absolutely key to solving the C-V-P analysis with multiple
products.
→ Most organizations don't maintain the exact same sales mix from year to
Summary
year, or even from month to month.
• The objective of C-V-P analysis is not always about getting to the → Hence, the more the actual sales mix turns out to be different from the
breakeven point. sales mix used in solving C-V-P equations, the more the results of the analysis
• In fact, it's almost always about achieving an income goal, which is won't be relevant to the actual sales situation.
referred to as the targeted profit.
• The transition from breakeven to targeted profit is simple. b) Just because the actual sales mix is shifting from what the organization
• Just change “Profit” in the C-V-P formula from zero to the targeted originally planned doesn't mean the organization won't break even or will fail to
profit amount. reach its targeted profit.
→ When an organization has more types of products or services in its sales
• Typically, organizations are focused on achieving an after-tax
mix, it has more possible solutions to achieve breakeven or targeted profit.
income goal.
→Hence, careful when applying C-V-P solutions to manage profit in an
• Hence, we need to adjust the after-tax targeted profit to a pre-tax organization with a shifting sales mix.
targeted profit before using it as “Profit” in the C-V-P formula.
c) Assume constant prices, variable cost rates, and total fixed costs in C-V-P
analysis.
PART 4 MULTIPLE PRODUCTS C-V-P →This is not a problem as long as the projected production volume stays
Overview within a “relevant range” for the organization.
▪ Up to this point, you have learned how to apply the C-V-P formula to
organizations selling only one product. Summary
▪ However, this is not the reality for most organizations.
▪ More often than not, organizations sell more than one type of product
• C-V-P Analysis for multiple products is a much more realistic
management setting than the analysis on a single product
or service.
▪ Explore how changes in unit sales mix affect operating income in • Most organization have multiple products or lines of service
multiple-product situations • Using the basket method to compute multiproduct C-V-P solutions
▪ Calculate multiple-product breakeven points given percentage share of helps keep the analysis focused on the classic C-V-P formula
sales and explain why there is no unique breakeven point in multiple- • The key is to build the C-V-P solution around the sales mix using a
product situations three-step approach:
1) Make a basket with the sales mix
Sales Mix Ratio 2) Solve the C-V-P for the basket
1) Most organizations sell more than one type of product or service into the 3) Open the basket and multiply the sales mix
market place. This reality complicates the C-V-P formula and CM analysis
2) When working in a multiple product context, it is crucial to compute the
current or desired sales mix.
PART 5 RISK AND UNCERTAINTY
Overview
▪ The C-V-P formula is based on very specific values for prices, volumes,
variable costs, and fixed costs.
▪ In the business world, there is a lot of uncertainty around these four
C-V-P inputs.
▪ Organizations also like to explore the impact on profit based on
anticipated changes in these same inputs.
▪ Organizations build some “margin of safety” into their C-V-P analysis
as well as how they explore the impact of anticipated changes through
a process called Sensitivity Analysis.

Managing with Uncertainty

- External environment factors create opportunities and threats, which in turn
create uncertainties on an organization's prices, volumes, and costs.
→Thus, manage within the context of uncertainty, particularly in C-V-P
analysis.

- There are many external factors that can affect the key inputs to C-V-P
analysis. These external factors include the following but not limited to these:
Competitors Suppliers Customers
Government Environment & Society Technology

The Margin of Safety Computation

a) The concept of uncertainty connects directly with the margin of safety
computation.

b) Significant uncertainty involving one or more of the four key C-V-P inputs
(price, volume, variable cost, fixed cost) requires a larger margin of safety.

c) Margin of safety is Current Sales−Breakeven Sales.

That is, the margin of safety indicates how much sales volume (in units) or
revenue (in dollars) can decrease before operating income becomes negative.

d) Margin of safety can also be expressed as a percentage

Formula →Margin of Safety ÷ Current Sales

e) Either percentage (based on breakeven sales or current sales) represents

the margin of safety
→ ensure to clearly understand what perspective is important in the analysis,
that is, how far current sales can decline before hitting the breakeven point or
how far current sales are above the breakeven point.

f) Note: Margin of safety computation can also be used to measure the

distance between current sales and the sales associated with some minimal
profit target.

Sensitivity Analysis with Sales

i. Given the necessary uncertainty surrounding the four key C-V-P inputs
(price, volume, variable cost, fixed cost), using sensitivity analysis can
determine the impact of changes in each input with respect to
breakeven or some other minimal profit target.
ii. The objective of sensitivity analysis:
identify the C-V-P input that has the greatest impact on the profit in
terms of potential change in the input.
iii. Holding the other C-V-P inputs constant, adjust each input by a
percentage or dollar amount change, and then observe the change in
profit. Higher effects on profit indicate higher sensitivity in the C-V-P
analysis to that particular price, volume, or cost input.

Summary
• In the business world, there is a lot of uncertainty around the four
C-V-P inputs of prices, volumes, variable costs, and fixed costs.
• As a result, organizations typically need to build some margin of
safety into their C-V-P analysis.
• Margin of Safety calculations represent the distance between
current sales and breakeven sales (or some other projected sales
level for the organization).
• In addition to Margin of Safety calculations, organizations can also
explore the impact on profit based on anticipated changes or
variance in the four C-V-P inputs.
• This process is called Sensitivity Analysis.