Cost-Value-Profit Relationships
Table of Contents
CVP Analysis Assumptions.............................................................................................................2
CVP Analysis Formulae.....................................................................................................................3
Break Even Point Analysis...............................................................................................................4
Formula Method.............................................................................................................................4
Equation Method...........................................................................................................................5
Margin of Safety.................................................................................................................................6
Operating Leverage...........................................................................................................................7
CVP Analysis Assumptions
When performing CVP analysis, we make a few assumptions:
1. The selling price is constant. It does not change based on volume.
2. Costs are linear and can be accurately divided into variable and fixed
elements. The variable element is constant per unit and the fixed unit is
constant in total over the entire relevant range.
3. In multiproduct companies, the sales mix is constant. The sales mix is the ratio
of production for the different products. Some products will have higher
demand and will need to be produced more. For example, a ratio of 6:1
indicates that one product is produced in 6 times the amount of the other.
4. In manufacturing companies, inventories do not change. The number of units
produced equals the number of units sold.
CVP Analysis Formulae
Acoustic Concepts, Inc.
Contribution Income Statement
For the month of June
Total($) Per Unit($)
Sales (400 units) 100,000 250
Variable Expenses (60,000) (150)
Contribution Margin 40,000 100
Fixed Expenses (35,000)
Net Operating Income 5,000
Contribution Margin
Contribution Margin ( CM ) Ratio=
Sales
$ 40,000
¿ ×100 %
$ 100,000
¿ 40 %
The Contribution Margin Ratio can be calculated using the total values or the per unit
values. Both will give the same result.
Variable Expense
Variable Expense Ratio=
Sales
$ 60,000
¿ ×100 %
$ 100,000
¿ 60 %
Notice that the Variable Expense Ratio and the Contribution Margin Ratio sum to
100 %. This is always true, so we can calculate one value given the other.
Break Even Point Analysis
The break even point (BEP) is the point at which the company has neither made
any profit nor faced any loss. It can be expressed as a dollar value (BEP [dollars]) or as
the quantity of units sold (BEP[units]).
We can calculate the BEP using either the formula method or the equation method.
In addition to the BEP, we can also calculate the unit or dollar sales to attain a
specified target profit. In the examples below, suppose that the target profit is
$ 40,000 .
Formula Method
¿ Expense
BE P [ units] =
CM per unit
$ 35,000
¿
$ 100
¿ 350 units
¿ Expense
BE P [ dollars ] =
CM Ratio
$ 35,000
¿
0.40
¿ $ 87,500
¿ Expense +Target Profit
Unit Sales ¿ Attain Target Profit=
CM per unit
$ 35,000+ $ 40,000
¿
$ 100
¿ 750 units
¿ Expense+ Target Profit
Dollar Sales ¿ Attain Target Profit=
CM Ratio
$ 35,000+ $ 40,000
¿
0.40
¿ $ 187,500
Equation Method
Sales=Variable Expense +¿ Expenses
The sales value specified in the table above includes the profit amount, so we
cannot use it directly. Instead, we have to calculate the total sales for Q units from
the price per unit. Similarly, the variable expenses will be lower, so we need to
calculate it from the variable expense per unit. Only the fixed cost will remain the
same.
250 Q=150 Q+35,000
250 Q−150 Q=35,000
100 Q=35,000
Q=350 units
BE P [ dollars ] =$ 250Q
¿ $ 250 ×350
¿ $ 87,500
250 Q=150 Q+35,000+ 40,000
250 Q−150 Q=75,000
100 Q=75,000
Q=750 units
Dollar Sales ¿ Attain Target Profit=$ 250 ×Q
¿ $ 250 ×750
¿ $ 187,500
Margin of Safety
The margin of safety is the difference between the break even point and the
amount of sales required to reach the expected profit. It is the amount by which total
sales can fall before we start to incur a loss.
Margin of Safety ∈D ollas=Total Budgeted ∨ Actual Sales−Break Even Sales
Margin of Safety ∈ Dollars
Margin of Safety ∈Percentage=
Total Budgeted∨ Actual Sales
Operating Leverage
The operating leverage measure the change in the net operating income due to a
change in the sales volume.
Contribution Margin
Degree of Operating Leverage=
Net Operating Income
A small increase in the sales volume can cause a huge change in the net operating
income. From the table provided at the top of this note,
Contribution Margin
Degree of Operating Leverage=
Net Operating Income
$ 40,000
¿
$ 5,000
¿8
Thus, for a 10% increase in the sales volume, we have a 8 ×10 %=80 % increase in the
net operating income.
If we are asked to prove this, we must prepare a new income statement, with the
sales volume increased by the amount required. This will also affect the total variable
expense and the contribution margin.
Acoustic Concepts, Inc.
Contribution Income Statement
For the month of June
Total($) Per Unit($)
Sales (440 units) 110,000 250
Variable Expenses (66,000) (150)
Contribution Margin 44,000 100
Fixed Expenses (35,000)
Net Operating Income 9,000
$ 9,000−$ 5,000
Increase ∈Net Operating Income= ×100 %
$ 5,000
¿ 80 %
Question: Would you recommend making the changes?
Answer: Yes. I recommend the changes should be made, since the changes increase
the company’s Net Operating Income from $60,000 to $72,000 and also increase the
Margin of Safety from $240,000 to $390,000.
