Chapter One
Cost-Volume-Profit (CVP) Analysis
1.1 Introduction
In this unit you will be introduced with one of the most powerful management accounting tool
that helps managers in quick decision about the income generated at different activity level. The
tool is termed as Cost-Volume-Profit (CVP) Analysis, as the relationship among cost, profit and
the volume of output or the level of activity is considered in the model.
Understanding the relationship between a firm’s costs, profits and its volume levels is very
important for strategic planning. When you are undertaking a new project, you will probably ask
yourself, “How many units do I have to produce and sell in order to breakeven?” The feasibility
of obtaining the level of production and sales indicated by that answer is very important in
deciding whether or not to move forward on the project in question. Similarly, before
undertaking a new project, you have to assure yourself that, you can generate sufficient profits in
order to meet the profit targets set by your firm. Thus, you might ask yourself, “How many units
do I have to sell in order to produce a target income?” Breaking Even? You could also ask, “If I
increase my sales volume by certain percent, what will be the impact on my profits?” The topics
in this unit are, therefore designed to acquaint you with the ability of applying Cost-Volume-
Profit (CVP) Analysis in answering different questions while you are taking part in planning
decision in different types of organizations.
Although the term “profit” is attached in the CVP model; it does not mean that, the application of
CVP analysis is limited to business organizations only. It can be used by government and
nongovernmental organizations (NGOs) as well in planning their activity levels in light of the
recourse availability and constraints.
1.2 Meaning, Underlying Assumptions and Importance of CVP Analysis
1.2.1 Meaning
Examining shifts in costs and volume and their resulting effects on profit is called cost-volume-
profit (CVP) analysis. This analysis is applicable in all economic sectors, including
manufacturing, wholesaling, retailing, and service industries and not-for- profit (NFP)
organizations. CVP can be used by managers to plan and control more effectively because it
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allows them to concentrate on the relationships among revenues, costs, volume changes, taxes,
and profits.
CVP analysis can be used to determine a company’s break-even point (BEP), which is that
level of activity, in units or Birr value, atwhich total revenues equal total costs. At breakeven, the
company’s revenues simplycover its costs; thus, the company incurs neither a profit nor a loss on
operatingactivities. Companies, however, do not wish merely to “break even” on operations.
The break-even point is calculated to establish a point of reference. Knowing BEP, managers are
better able to set sales goals that should generate income from operations rather than produce
losses. CVP analysis can also be used to calculate the sales volume necessary to achieve a
desired target profit. Target profit objectives can be stated as either a fixed or variable amount
on a before- or after-tax basis. Because profit cannot be achieved until the break-even point is
reached, the starting point of CVP analysis is BEP.
1.2.2 Underlying Assumptions of CVP Analysis
CVP analysis is a short-run model that focuses on relationships among several items: selling
price, variable costs, fixed costs, volume, and profits. This model is a useful planning tool that
can provide information on the impact on profits when changes are made in the cost structure or
in sales levels, Hence;
CVP analysis is based on the following general assumptions:
1. Changes in level of activity are the only factors that affect costs and revenue.
2. Total costs can be separated in to variable and fixed components.
3. When represented graphically, the behavior of total revenues and total costs are linear
(Straight line) in relation to output level.
4. Selling price per unit, variable cost per unit and fixed costs are known and constant.
These assumptions limit not only the volume of activity for which the calculations can be made,
but also the time frame for the usefulness of the calculations to that period for which the
specified revenue and cost amounts remain constant. Changes in either selling prices or costs
will require that new computations be made for break-even and product opportunity analyses.
1.3 Applications of CVP Analysis
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1.3.1 Break Even Analysis
CVP analysis has wide-range applicability. It can be used to determine a company’s break-even
point (BEP), which is that level of activity, in units or dollars/Birr, at which total revenues equal
total costs. At breakeven, the company’s revenues simply cover its costs; thus, the company
incurs neither a profit nor a loss on operating activities.
At the breakeven point total revenue is equal to total cost (both variable and fixed)/profit is
zero.
For instance Sebastopol Cinema sold 4,800 tickets during a show one month run. The following
contribution margined approach income statement show that the operating income for the month
will be zero:
Sales Revenue (4800 X Br25) --------------------------- Br 120, 000
Less Variable Cost (4800 X Br 15) -------------------------- 72,000
Total Contribution Margin----------------------------------Br 48,000
Less Fixed Costs-------------------------------------------------- 48,000
Operating Income---------------------------------------------------Br 0
The income statement above highlights (1) the distinction between variable and fixed cost and
(2) the total contribution margin, which is the amount that contributes towards covering
Sebastopol Cinema’s fixed cost and income generation. To state it differently, each ticket sold
add Birr 10 to the firm’s bottom line profit. The Birr 10 unit contribution margin is derived by
deducting the unit variable cost Birr 15 from Birr 25 the unit selling price of a ticket.
How could you compute Sebastopol Cinema’s breakeven point if you didn’t already know it is
Birr 4,800 tickets per month? Well on the following discussion you will get the basics of CVP
analysis to determine BEP and other application. CVP analysis can be done using three
alternative approaches, namely: contribution margin approach, equation approach and graphical
approach.
In discussing CVP application we will assume that the following variables have the meanings
given below:
SP = Selling Price Per Unit
Q = Units Produced and Sold
VCU = Variable Cost Per Unit
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CMU=contribution margin per Unit
CM%= contribution margin percentage (CMU÷SP)
FC = Total Fixed Costs
TOI =Target operating Income
TNI=Target Net Income
t = Tax rate
1.3.1.1 Equation Method
In using equation approach to CVP analysis, you need to convert your income statement in the
following equation form.
Revenue –Variable Costs- Fixed Costs = Operating Income
Your Sales Revenue is equal to the number of units sold times the price you get for each unit
sold:
Sales Revenue = SPQ
Assume that you have a linear cost function, and your total costs equal the sum of your Variable
Costs and Fixed Costs:
Total Costs = Variable costs + Fixed costs
The profit equation can, therefore rewritten as:
(SPXQ) - (VCUXQ) + FC = OI
This equation provides the most general and easiest approach to remember approach to any CVP
situation. The determination of breakeven level using this method can easily performed by
making the operating income on the right hand side of the equation zero. Here the basic
assumption is that, when you are at breakeven, your Sales Revenue minus your Total Costs is
zero.
At breakeven point,
(SPXQ) - (VCUXQ) + FC = 0
From the information given above for the Sebastopol Cinema, you can determine the breakeven
point (BEP) using the equation approach as follows:
(Br25 X Q) – (Br15 X Q) – Br48, 000 = 0
Br10Q = Br 48,000
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Q= 4,800
If Sebastopol sells fewer than 4800 tickets, it will have a loss, if it sells 4800 tickets, it will
breakeven; and if the sales are more than 4800 units, it will make a profit.
The breakeven point stated in units can be stated in terms of Birr by multiplying the breakeven
quantity and unit selling price. The breakeven point in Birr= BEQ x SP
= 4,800 x Br25
= Br120, 000
1.3.1.2 Contribution Margin Approach
The contribution margin technique is merely a short version of the equation technique. The
formulas used in the determination of the breakeven point in unit as well as in value are derived
by the rearrangement of the terms in the equation method above, which is
(SP x Q) – (VCU x Q) – FC = OI
Re-written equation takes the following format:
(SP-VCU) x Q = FC + OI
That is, Q= FC + OI/ (SP-VCU)
The difference between unit selling price and unit variable cost is termed as unit contribution
margin. You can replace the (P-V) by the term "Contribution Margin per Unit (CMU),
Q = FC + OI/CMU
As you know from the discussion above at breakeven point the target operating income is Birr 0,
so replacing OI by 0, you will get,
Q = FC/ (SP-VCU)
A. Breakeven point in units using contribution Margin Approach
Breakeven point in units using this formula is determined by dividing the total fixed cost by the
contribution margin per unit due to the fact that this approach centers on the idea that each unit
sold provides a certain amount of fixed costs. When enough units have been sold to generate a
total contribution margin equals to the total expense and only after that point the units sold
contributes for profit of the organization.
The breakeven number of tickets that Sebastopol Cinema must sell to reach at breakeven using
this method can be determined as:
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Q = FC/CMU
Q = Br 48, 000/Br10
Q = 4,800 units
B. Determining breakeven point in terms of sales value (Dollar/Birr)
To find the breakeven sales value, you can use contribution margin percentage in place of
contribution margin per unit in the formula you used in the determination of breakeven units.
Contribution margin percentage is simply the ratio of contribution margin to selling price.
CM% = CMU/USP
It can also determined by dividing the total contribution margin to total sales when the unit
selling price and variable cost is not known. We will see how this formula is used in such a
situation later. Before that let see how the formula works using the above example.
CM % on our example of Sebastopol Cinema = UCM/USP
= Br 10/ Br 25
= 0.4
This can be interpreted as, units sold cover variables costs and contribute 40 percent to cover
fixed cost and increase in profit.
The break even sales amount (Birr) for Sebastopol Cinema = FC/CM%
= 48,000/0.40
= Br 120,000
The breakeven sales determined using equation method was a mere multiplication of the
breakeven point in unit and the unit selling price (4800 units x Br 25) which is exactly the same
with what you determined using a more complicated contribution margin approach.
Why do you think using the contribution margin approach is essential?
Well, sometimes you will be given only the income statement and asked to determine the
breakeven sales without sufficient information about units selling price and unit variable cost. In
this case, only using the contribution margin ratio you can determine the breakeven point in sales
by dividing total fixed cost by CM ratio gives the break-even point in sales dollars.
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For example, Jimma Electronics Co. produces portable radios. It has released the following
Variable Costing Income Statement. This is the only financial information that we have
regarding the company’s operations:
Sales Revenue--------- 100,000
Less Variable Costs------30,000
Contribution Margin----- 70,000
Less Fixed Costs--------- 50,000
Operating Income ------- Br 20,000
What is the Break-Even point for Jimma Electronics Co? You do not know the number of units
that Jimma Electronics sold in a year. You do not also know the Price or the Variable Cost per
unit. Although you do not know the price or the Variable Cost per unit, you are still able to
calculate the Contribution Margin Ratio.
Contribution ratio can be determined by dividing total contribution margin to total sales.
CM% in this case is, therefore, determined as follows:
= Br 70,000 ÷ Br 100,000 or 1- variable cost ratio
= 0.7 0r 70% 1- (variable cost ÷ sales)
1-(30,000 ÷ 100,000)
0.7 Or 70%
The breakeven point in sales is also determined by dividing the total fixed cost by the
contribution margin ratio determined above as follows:
= FC/CM%
= 50,000/0.7
=Br 71,428.57
Keep in mind the reason that Jimma Electronics’ Sales Revenue is lower than it was before is
because the company sold fewer units. Keeping the price and Variable Cost per unit remained
unchanged. Let's check if Breaks Even at this Sales Revenue figure:
Sales Revenue: -------------------------------------- Br 71,428.57
Less Variable Costs (30% of 71,428.57) -------------- 21,428.57
Contribution Margin------------------------------------Br 50,000
Less Fixed Costs--------------------------------------------- 50,000
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Operating Income -------------------------------------------- 0
1.3.1.3 Graphical Approach
You have seen howsolutions to break-even problems are determined using an algebraic formula.
However, sometimes managers need information in more visual format, such as graphs. In this
approach you can construct a CVP graph by plotting total cost and total revenue graph at
different activity level. The breakeven point is found at the intersection point of total revenue and
total cost lines.
The chart or graph is constructed as follows:
1. Plot fixed costs, as a straight line parallel to the horizontal axis
2. Plot sales revenue and variable costs from the origin
3. Total costs represent fixed plus variable costs.
4. The breakeven point represents the intersection point of total revenue and total cost
lines
Now you can draw a CVP graph to Sebastopol Cinema following the steps given above and
locate the breakeven point.
Birr Total Revenue
Line
Operating Profit
Total Cost Line
Operating Loss
120,000
Total Variable Cost
48,000
Breakeven Point
Fixed Cost Line
Fixed Cost
4,800 Units
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The breakeven points for Sebastopol cinema can determined from the graph by identifying the
level of output and sales value where the total revenue and total cost line cross to each other. In
the case of Sebastopol cinema this happened when 4800 tickets are sold for birr 120,000 in
which both the unit and the Birr value are similar with what have been determined in the
equation and contribution margin approaches. The graphical approach is usually preferred by
managers as it can provide a detail insight of the cost volume and profit relationship pictorially.
1.3.2 Target Operating Income Analysis
Using CVP analysis managers can determine the total sales in unit and Birr/Dollar needed to
reach the target profit level. The computation of sales volume in unit and/ or in amount to attain
the targeted profit is similar with that of the break even analysis, except that the targeted profit is
more than offsetting the cost. For instance, the management of Sebastopol Cinema desires to get
Br 9000 profit for the coming month, instead of operating at breakeven point, how many tickets
must be sold? Managers want to answer this question to provide the necessary resource support
to attain the desired profit at already determined volume of activity. The analysis can be
performed using equation method or contribution margin approach on the basis of personal
preference.
See both the methods using the information given for Sebastopol Cinema to determine the target
sales in unit and Birr to that enable the firm to earn the targeted profit of birr 9,000 cab be
determined using the equation method and contribution margin method as follows:
Equation Method to Determine Contribution Margin Approach
(Target sales unit) (Target sales unit)
(SP x Q) - (VCU x Q) -FC= TOI Q = FC +TOI/ CMU
(25 x Q) – (15 x Q) - 48,000= 9000 Q = (48,000 + 9,000)/10
10Q= 57,000 Q= 5,700
Q= 5,700
Equation Method to Determine Contribution Margin Approach
(Target sales in birr) (Target sales in birr)
TR= SP x Q Target Sales in Birr = (FC + TOI)/CM%
=25 x 5700 = (48,000 + 9000)/ 40%
= Br 142,500 = Birr 142, 500
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Both the methods provided similar result that the cinema must sell 5,700 tickets at a total of Birr
142, 500 to meet its target profit goal of birr 9000.
Here you can recognize that each ticket sales beyond the breakeven point contributes to the
firms operating income.
1.3.3 The Impact of Income Tax on CVP Analysis
Profit seeking enterprises must pay tax on their profit, meaning that target income figures are set
at high enough to cover the firm’s tax obligation to the government. The relationship between an
organization‘s before tax income and after tax income is expressed in the following formula:
After Tax income = Before Tax Income – Income Taxes
NIAT = NIBT- (NIBT x t)
= NIBT x (1-t)
Dividing both sides by (1-t) you can get:
NIAT/ (1-t) = NIBT
Which gives you the desired before tax income that will generate the desired after tax income,
given the company’s tax rate.
For instance, if the target profit given for Sebastopol Cinema above is expressed on after tax
basis and the firm is subject to a 40 percent income tax rate, what will be the required sales of
ticket in units and Birr? If you want to know how many units that you need to produce and sell in
order to generate a target Net Income (or after-tax profit), just convert the after-tax number into a
before-tax number.
NIBT = NIAT/ (1-t)
=Br 9000/ (1-0.4)
= Br 15,000
You can then substitute the before-tax profit figure in the formulas used in target operating
income analysis. The analysis of sales of tickets and amount of Sebastopol cinema to earn the
desired profit after tax can be determined using the equation and contribution margin approach as
shown on the following table:
Equation Method to Determine Contribution Margin Approach
(Target sales unit) (Target sales unit)
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(SP x Q) - (VCU x Q) -FC= TOIBT Q = FC +TOIBT/ CMU
(25 x Q) – (15 x Q) - 48,000= 15,000 Q = (48,000 + 15,000)/10
10Q= 63,000 Q= 6,300
Q= 6,300
Equation Method to Determine Contribution Margin Approach
(Target sales in birr) (Target sales in birr)
TR= SP x Q Target Sales in Birr = (FC + TOIBT)/CM%
=25 x 6300 = (48,000 + 15,000)/40%
= Br 157,500 = Birr 157, 500
1.3.4 Limitation of CVP-Analysis
Cost classification as variable and fixed
Mixed costs or semi variable costs?
Selling price remains constant and linear.
Variable cost remains constant and linear.
Fixed costs remain constant.
Changes with the change of the level of activity?
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Individual Assignment (10%)
Assume that NOTA Printers provides secretarial and printing services. The unit variable cost and
selling price are Br 0.75 & Br 1.00, for secretarial, respectively, and Br 0.25 & Br 0.75 for
printing, respectively. Its monthly fixed costs for all services total Br 3,000. The company sells
printing, photocopying and secretarial services in the ratio of 2:5:3.
Required:
a) How many pages must ABC print/copy/write in a month to breakeven?
b) How many pages must ABC print/copy/write to earn Br. 900 profit per month?
c) How much sales revenue should ABC earn in a month to breakeven?
d) How many pages must ABC print/copy/write to earn Br.700 profit after 30% income tax?
NOTE: Follow all the necessary steps in calculation each question
Submission deadline: 22/07/2010 E.C, Submission after this deadline will not
accepted.
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