Chapter 4:
COST-VOLUME-
PROFIT ANALYSIS:
A MANAGERIAL
PLANNING TOOL
CORNERSTONES OF MANAGERIAL ACCOUNTING, 6E
BREAK-EVEN POINT IN UNITS
AND IN SALES DOLLARS
Companies use CVP analysis to help them reach important
benchmarks, like breakeven point.
The break-even point is the point where total revenue equals
total cost (i.e., the point of zero profit).
Also the level of sales at which contribution margin just
covers fixed costs and when operating income is equal to zero.
Since new companies typically experience losses (negative
operating income), they view their first break-even period as a
significant milestone.
LO-1
USING OPERATING INCOME
IN C-V-P ANALYSIS
For CVP analysis, it is useful to organize costs into fixed and
variable components.
Below is the income statement format that is based on the
separation of costs into fixed and variable components is called
the contribution margin income statement.
© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in
part, except for use as permitted in a license distributed with a certain product or service or otherwise on a
password-protected website for classroom use.
LO-1
USING OPERATING INCOME
IN COST-VOLUME-PROFIT
ANALYSIS (CONT.)
Direct Variable selling and
materials administrative costs
Direct labor
Variable
overhead
Fixed selling and
Fixed administrative costs
overhead
LO-1
USING OPERATING INCOME
IN C-V-P ANALYSIS
Contribution margin is the difference between sales
and variable expense.
The amount of sales revenue left over after all the
variable expenses are covered that can be used to
contribute to fixed expense and operating income.
LO-1
BREAK-EVEN POINT IN
UNITS
If the contribution margin income statement is recast as an equation, it
becomes more useful for solving CVP problems.
Basic CVP Equation
Break-even units are equal to the fixed cost divided by the contribution margin per
unit.
LO-1
BREAK-EVEN POINT IN
SALES DOLLARS
Managers using CVP analysis may use sales revenue as the measure of
sales activity instead of units sold. A units sold measure can be converted
to a sales revenue measure by multiplying the unit selling price by the
units sold:
For example, the break-even point for Whittier is 600
mowers; the selling cost is $400 per mower.
Breakeven in Sales $’s = 600 x $400 = $240,000 LO-1
VARIABLE COST RATIO AND
CONTRIBUTION MARGIN RATIO
Any answer expressed in units sold can be easily
converted to one expressed in sales revenues.
Variable Cost Ratio Contribution Margin Ratio
Alternatively:
LO-1
FIXED COST’S RELATIONSHIP
WITH VARIABLE COST
CONTRIBUTION & MARGIN
RATIOS
Since the total contribution margin is the revenue remaining after
total variable costs are covered, it must be the revenue available
to cover fixed costs and contribute to profit.
How does the relationship of fixed cost to contribution margin
affect operating income?
There are three possibilities:
Fixed cost equals contribution margin; operating income is zero; the
company breaks even.
Fixed cost is less than contribution margin; operating income is greater than
zero; the company makes a profit.
Fixed cost is greater than contribution margin; operating income is less than
zero; the company makes a loss.
LO-1
UNITS TO BE SOLD TO
ACHIEVE A TARGET INCOME
While the break-even point is useful information and an
important benchmark for relatively young companies,
most companies would like to earn operating income
greater than $0.
CVP allows us to do this by adding the target income
amount to the fixed cost.
First, let’s look in terms of units that must be sold.
LO-2
SALES REVENUE TO
ACHIEVE A TARGET INCOME
How much sales revenue must Whittier generate to earn an
operating income of $37,500?
This question is similar to the one we asked earlier in
terms of units but phrases the question directly in terms of
sales revenue.
To answer the question, add the targeted operating income
of $37,500 to the $45,000 of fixed cost and divide by the
contribution margin ratio. This equation is:
LO-2
IMPACT OF CHANGE IN REVENUE
ON CHANGE IN PROFIT
Assuming that fixed costs remain unchanged, the
contribution margin ratio can find the profit impact of a
change in sales revenue.
To obtain the total change in profits from a change in
revenues, multiply the contribution margin ratio times the
change in sales:
Change Contribution Change
in = Margin x in
Profits Ratio Sales
LO-2
GRAPHS OF COST-VOLUME-
PROFIT RELATIONSHIPS: THE
PROFIT-VOLUME GRAPH
A profit-volume graph visually portrays
the relationship between profits (operating
income) and units sold.
The profit-volume graph is the graph of the
operating income equation:
Operating income = (Price x Units) –
(Unit variable cost x Units) – Total
fixed cost
In graph, operating income is the
dependent variable, and units is the
independent variable.
LO-3
THE COST-VOLUME-PROFIT
GRAPH
The cost-volume-profit graph depicts the relationships among cost,
volume, and profits (operating income).
LO-3
CVP ANALYSIS
ASSUMPTIONS
Major assumptions of CVP analysis include:
1 2
Linear revenue and cost
Selling prices and costs
functions remain constant
are known with certainty.
over the relevant range.
3 4
Sales mix is known with
All units produced are
certainty for multiple-
sold; no finished goods
product break-even
inventories remain.
settings.
LO-3
MULTIPLE-PRODUCT
ANALYSIS
Cost-volume-profit analysis is simple in the single-product setting.
However, most firms produce and sell a number of products or
services.
How do we adapt the formulas used in a single-product setting to a
multiple-product setting?
One important distinction is to separate direct fixed expenses from
common fixed expenses.
Direct fixed expenses are those fixed costs that can be traced to
each segment and would be avoided if the segment did not exist.
Common fixed expenses are the fixed costs that are not traceable
to the segments and would remain even if one of the segments was
eliminated.
LO-4
BREAK-EVEN CALCULATIONS
FOR MULTIPLE PRODUCTS
When more than one product is produced and sold, managers
must estimate the sales mix and calculate a package contribution
margin.
Sales mix is the relative combination of products being sold by a
firm.
Fixed Costs
Break-Even Packages =
Package Contribution Margin
© 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in
part, except for use as permitted in a license distributed with a certain product or service or otherwise on a
password-protected website for classroom use.
LO-4
COST-VOLUME-PROFIT ANALYSIS
AND RISK AND UNCERTAINTY
Managers must be aware of so many factors in our
dynamic world. CVP analysis is a tool that managers use
to handle risk and uncertainty.
?
g e s in Risks?
n
Cha es??
pric
Fixed
?
ty ?? costs?
a in
ert
c Variable
Un
costs??
LO-5
METHODS TO DEAL WITH
UNCERTAINTY AND RISK
1. Management must realize the uncertain
nature of future prices, costs, and
quantities.
2. Management must assume a breakeven
“band” rather than a breakeven point.
3. Managers should use sensitivity or
“what- if” analyses.
LO-5
MARGIN OF SAFETY
The margin of safety is the units sold or the revenue earned above the break-
even volume.
Example: If the break-even volume for a company is 200 units and the
company is currently selling 500 units, the margin of safety in units is:
Sales - Break-even units = 500 – 200 = 300 units
If the break-even volume for a company is $200,000 and the current revenues
are $500,000, the margin of safety in sales revenue is:
Revenue - Break-even volume = $500,000 – 200,000 = $300,000
The margin of safety as a percentage of total sales dollars can then be
expressed as:
Margin of safety ÷ Revenues = $300,000 ÷ $500,000 = 60%
LO-5
OPERATING LEVERAGE
Operating leverage is the use of fixed costs to extract
higher percentage changes in profits as sales activity
changes.
Measure of the proportion of fixed costs in a company’s cost
structure.
Used as an indicator of how sensitive profit is to changes in sales
volume.
The degree of operating leverage (DOL) can be measured
for a given level of sales by taking the ratio of contribution
margin to operating income or:
Contribution margin ÷ Operating income
LO-5
SUMMARY OF OPERATING
LEVERAGE
Operating Leverage
HIGH LOW
% profit increase with Large Small
sales increase
% loss increase with Large Small
sales decrease
LO-5
SENSITIVITY ANALYSIS
LO-5
