Cost-Volume-Profit (CVP) Analysis

Chapter 3

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-1
 Cost-Volume-Profit Assumptions

1. Changes in the level of revenues and costs arise

only because of changes in the number of units
produced and sold.
2. Total costs can be divided into a fixed component
and a component that is variable with respect to
the level of output.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-2
 Cost-Volume-Profit Assumptions

3. When graphed, the behavior of total revenues

and total costs is linear (straight-line) in relation
to output units within the relevant range and
time period.
4. The unit selling price, unit variable costs, and
total fixed costs are known and constant.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-3
 Cost-Volume-Profit Assumptions

5. The analysis either covering a single product or

assumes that the sales mix - when multiple
products are sold - will remain constant as the
level of total units sold changes.
6. All revenues and costs can be added and
compared without taking into account the time
value of money.
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-4
 Cost-Volume-Profit Assumptions
and Terminology

Operating income
= Total revenues from operations
– Cost of goods sold and operating costs

Net income = Operating income – Income taxes

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-5
 Essentials of Cost-Volume-Profit
(CVP) Analysis Example
Assume that the Pants Shop can purchase pants
for $32 from a local factory; other variable costs
amount to $10 per unit.

The average selling price per pair of pants is $70

and total fixed costs amount to $84,000.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-6
 Essentials of Cost-Volume-Profit
(CVP) Analysis Example

How much revenue will the business receive if

2,500 units are sold?
2,500 × $70 = $175,000
How much variable costs will the business incur?
2,500 × $42 = $105,000
O.I. = $175,000 – 105,000 – 84,000 = ($14,000)
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-7
 Essentials of Cost-Volume-Profit
(CVP) Analysis Example

What is the contribution margin per unit?

$70 – $42 = $28 contribution margin per unit
What is the total contribution margin when
2,500 pairs of pants are sold?
2,500 × $28 = $70,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-8
 Essentials of Cost-Volume-Profit
(CVP) Analysis Example

Contribution margin percentage (contribution

margin ratio) is the contribution margin per
unit divided by the selling price per unit.
What is the contribution margin percentage?
$28 ÷ $70 = 40%

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3-9
 Essentials of Cost-Volume-Profit
(CVP) Analysis Example

If the business sells 3,000 pairs of pants,

revenues will be $210,000 and contribution
margin would equal 40% × $210,000 = $84,000.

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©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 10

 Learning Objective 3

Determine the breakeven point

and output level needed to achieve
a target operating income using:
the equation, contribution margin,
and graph methods.
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 11
 At Breakeven Point

Sales – Variable
expenses =
Fixed
expenses

Total revenues = Total costs

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 12

 Abbreviations

SP = Selling price
VCU = Variable cost per unit
CMU = Contribution margin per unit
CM% = Contribution margin percentage
FC = Fixed costs

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 13

 Abbreviations

Q = Quantity of output units

manufactured & sold
OI = Operating Income
TOI = Target Operating Income
TNI = Target Net Income

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 14

 Equation Method

(Selling price × Quantity sold) – (Variable unit cost

× Quantity sold) – Fixed costs = Operating income
Let Q = number of units to be sold to break even
$70Q – $42Q – $84,000 = 0
$28Q = $84,000
Q = $84,000 ÷ $28 = 3,000 units

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 15

 Contribution Margin Method

$84,000 ÷ $28 = 3,000 units

$84,000 ÷ 40% = $210,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 16

 Graph Method
Breakeven
378
336
294
252
$(000)

210
168
126 Fixed costs
84
42
0
0 1000 2000 3000 4000 5000
Units
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 17
 Target Operating Income

The Point at Which We Realize TOI =

(Fixed costs + Target operating income)
divided either by Contribution margin
percentage or Contribution margin per unit

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 18

 Target Operating Income

Assume that management wants to have an

operating income of $14,000.
How many pairs of pants must be sold?
($84,000 + $14,000) ÷ $28 = 3,500
What dollar sales are needed to achieve this income?
($84,000 + $14,000) ÷ 40% = $245,000
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 19
 Learning Objective 4

Understand how income

taxes affect CVP analysis.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 20

 Target Net Income
and Income Taxes Example
Management would like to earn
an after tax income of $35,711.
The tax ratio is 30%.
What is the target operating income?
Target operating income
= Target net income ÷ (1 – tax ratio)
TOI = $35,711 ÷ (1 – 0.30) = $51,016
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 21
 Target Net Income
and Income Taxes Example

How many units must be sold?

Revenues – Variable costs – Fixed costs
= Target net income ÷ (1 – tax rate)
$70Q – $42Q – $84,000 = $35,711 ÷ 0.70
$28Q = $51,016 + $84,000
Q = $135,016 ÷ $28 = 4,822 pairs of pants
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 22
 Target Net Income
and Income Taxes Example

Proof:
Revenues: 4,822 × $70 $337,540
Variable costs: 4,822 × $42 (202,524)
Contribution margin $135,016
Fixed costs (84,000)
Operating income 51,016
Income taxes: $51,016 × 30% (15,305) app.
Net income $ 35,711
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 23
 Learning Objective 5

Explain CVP analysis

in decision making and
how sensitivity analysis helps
managers cope (deal)
with uncertainty.
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 24
 Using CVP Analysis Example

Suppose the management anticipates

selling 3,200 pairs of pants.
Management is considering an advertising
campaign that would cost $10,000.
It is anticipated that the advertising will
increase sales to 4,000 units.
Should the business advertise?
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 25
 Using CVP Analysis Example
3,200 pairs of pants sold with no advertising:
Contribution margin $89,600
Fixed costs (84,000)
Operating income $ 5,600
4,000 pairs of pants sold with advertising:
Contribution margin $112,000
Fixed costs (94,000)
Operating income $ 18,000
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 26
 Using CVP Analysis Example

Instead of advertising, management is

considering reducing the selling price
to $61 per pair of pants.
It is anticipated that this will increase
sales to 4,500 units.
Should management decrease the selling
price per pair of pants to $61?
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 27
 Using CVP Analysis Example

3,200 pairs of pants sold with no change

in the selling price:
Operating income = $5,600
4,500 pairs of pants sold at a reduced selling price:
Contribution margin: (4,500 × $19) $85,500
Fixed costs (84,000)
Operating income $ 1,500
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 28
 Learning Objective 6

Use CVP analysis to plan

fixed and variable costs.
(V. Important)

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 29

 Alternative Fixed/Variable Cost
Structures Example

Suppose that the factory, the Pants Shop is using to

obtain the merchandis, offers the following:
Decrease the price they charge from $32 to $25 and
charge an annual administrative fee of $30,000.
What is the new contribution margin?

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 30

 Alternative Fixed/Variable Cost
Structures Example

$70 – ($25 + $10) = $35

Contribution margin increases from $28 to $35.
What is the contribution margin percentage?
$35 ÷ $70 = 50%
What are the new fixed costs?
$84,000 + $30,000 = $114,000
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 31
 Alternative Fixed/Variable Cost
Structures Example
Management questions what sales volume
would yield an identical operating income
regardless of the arrangement.
28x – 84,000 = 35x – 114,000
114,000 – 84,000 = 35x – 28x
7x = 30,000
x = 4,286 pairs of pants app.
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 32
 Alternative Fixed/Variable Cost
Structures Example

Cost with existing arrangement

= Cost with new arrangement
.60x + 84,000 = .50x + 114,000
.10x = $30,000  x = $300,000
($300,000 × .40) – $ 84,000 = $36,000
($300,000 × .50) – $114,000 = $36,000
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 33
 Operating Leverage

Operating leverage describes the effects that

fixed costs have on changes in operating
income as changes occur in units sold.
Organizations with a high proportion of fixed
costs have high operating leverage.
(Pay a Good Attention)

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 34

 Operating Leverage Example

Degree of operating leverage

= Contribution margin ÷ Operating income
What is the degree of operating leverage
of the Pants Shop at the 3,500 sales level
under both arrangements?
Existing arrangement:
3,500 × $28 = $98,000 contribution margin
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 35
 Operating Leverage Example

$98,000 contribution margin – $84,000 fixed costs

= $14,000 operating income
$98,000 ÷ $14,000 = 7.0
New arrangement:
3,500 × $35 = $122,500 contribution margin

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 36

 Operating Leverage Example

$122,500 contribution margin

– $114,000 fixed costs = $8,500
$122,500 ÷ $8,500 = 14.4
The degree of operating leverage at a given level
of sales helps managers calculate the effect of
fluctuations in sales on operating income.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 37

 Learning Objective 7

Apply CVP analysis to a company

producing different products.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 38

 Effects of Sales Mix on Income

Pants Shop Example

Management expects to sell 2 shirts at $20 each
for every pair of pants it sells.
This will not require any additional fixed costs.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 39

 Effects of Sales Mix on Income

Suppose that variable cost/shirt = $9

Contribution margin per shirt: $20 – $9 = $11

What is the contribution margin of the mix?

$28 + (2 × $11) = $28 + $22 = $50

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 40

 Effects of Sales Mix on Income

$84,000 fixed costs ÷ $50 = 1,680 packages

1,680 × 2 = 3,360 shirts
1,680 × 1 = 1,680 pairs of pants
Total units = 5,040

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 41

 Effects of Sales Mix on Income

What is the breakeven in dollars?

3,360 shirts × $20 = $ 67,200
1,680 pairs of pants × $70 = 117,600
$184,800

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 42

 Effects of Sales Mix on Income

What is the weighted-average budgeted

contribution margin?
Pants: 1 × $28 + Shirts: 2 × $11
= $50 ÷ 3 = $16.667

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 43

 Effects of Sales Mix on Income

The breakeven point for the two products is:

$84,000 ÷ $16.667 = 5,040 units
5,040 × 1/3 = 1,680 pairs of pants
5,040 × 2/3 = 3,360 shirts

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 44

 Effects of Sales Mix on Income

Sales mix can be stated in sales dollars:

Pants Shirts
Sales price $70 $40
Variable costs 42 18
Contribution margin $28 $22
Contribution margin ratio 40% 55%

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 45

 Effects of Sales Mix on Income

Assume the sales mix in dollars

is 63.6% pants and 36.4% shirts.
Weighted contribution would be:
40% × 63.6% = 25.44% pants
55% × 36.4% = 20.02% shirts
45.46%

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 46

 Effects of Sales Mix on Income

Breakeven sales dollars is $84,000

÷ 45.46% = $184,778 (rounding).
$184,778 × 63.6% = $117,519 pants sales
$184,778 × 36.4% = $ 67,259 shirt sales

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 3 - 47

 End of Chapter 3

Thanks for Good Listening

Prof. Adel T. Fayed

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 2 - 48