St.

Mary’s University, Faculty of Accounting and Finance

CHAPTER - ONE
COST -VOLUME -PROFIT (CVP) ANALYSIS
1.1 Introduction
The first step in CVP analysis classifying costs as variable and fixed based on their behavior.
Variable Cost - is a cost that changes in direct proportion to changes in the cost driver.
Fixed Cost- is a cost that remains constant over a given period called relevant range. Variable cost per
unit is constant -where as fixed cost per unit changes in opposite direction with an increase in cost driver
Relevant Range: is the limit of cost driver activity with in which a specific relationship between the
cost & the cost driver is valid.
CVP Analysis: is one of the most powerful tools that managers have at their command. It helps them
understand the interrelationship between cost, volume, and the profit of an organization and hence, it
helps to make important decisions like for example:
 what products to manufacture or sell
 what price policy to follow
 what marketing strategy to apply
1.2 Basics of CVP Analysis
Consider the following example: Mary Alebachew plans to sell a home-office software package at a
heavily attended two-month computer convention (Exhibition) in Addis. Mary can purchase this
software from computer software wholesaler at Br.120 per package. The packages will be sold at Br 200
each. She has already paid Br. 2000 for the booth rental for a month convention. Assume there are no
other costs and number of units sold is 100.
Summary of the data:
Number of units sold 100 units
Selling price per unit Br.200
Variable cost per unit 120
Monthly fixed costs 2000
A. Contribution Margin
Contribution margin is the difference of sales revenue and all variable costs. Thus the contribution
margin is the amount, which contributes to cover the fixed cost. Once the fixed cost is recovered, the
amount will contribute for profit of the period.

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St. Mary’s University, Faculty of Accounting and Finance

. Total Per unit

Sales Br. 20,000 Br. 200
Less: VC 12,000 120
Contribution Margin Br. 8,000 Br. 80
Less: Fixed Costs 2000
Operating Income Br. 6,000

Notice that sales, variable expenses and contribution margin are expressed on a per unit basis as well as
in total.
B. Contribution Margin Ratio:
The contribution margin as a percent of total sales is referred to as the contribution margin ratio.

CM percentage (CM ratio) = = 80/200 =40%

CM % -Shows CM achieved per dollar of revenue.

1.3 BREAKEVEN POINT (BEP) Analysis
Breakeven point is an important aspect of CVP analysis. Managers usually ask ‘what volume of sales do
we need to breakeven? ’when they starting a new product line. Breakeven point is the level of out put
where total revenues equal total costs i.e. company’s profit is zero. It tells mgrs what level of sales they
must generate to avoid a loss.
THREE METHODS TO DETERMINE BEP
A. EQUATION METHOD
It is used to determine the BEP and focus on the contribution margin approach. It expresses the income
statement in equation form as follows:
Net Income = Revenues - Variable costs - Fixed costs
= (SP x Q) - (V x Q) - FC
= Q = FC/(SP-VC)
For Mary, the BEP is:
0 = (200 x Q) - (120 x Q) – 2000  80Q= 2000  Q = 25 units.
IF Mary sells fewer than 25 units, she will have a loss; if she sells 25 units she will break even; and if
she sells more than 25 units, she will make a profit.
BEP in dollars = SP*BEPQ  25 x 200 = $ 5,000
B. CONTRIBUTION MARGIN METHOD
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It uses the equation method to determine the BEP. Taking the above general Equation we've:

NI = (SP x Q) - (V x Q) – FC  NI + FC = Q(SP - V) Q=

but SP - V = contribution per unit and by definition, at BEP, NI equals zero.

 i.e. Break even in quantity

Break even in quantity = = 25 units

Break even Revenue = Break even quantity x Price per unit

BE Rev. = , UCM/SP = CM % 

BEP in revenue for the above example = = $ 5,000

C. Graph Method
CVP Relationships in Graphic Form: the relationships among revenue, cost, profit, and volume can
be expressed graphically by preparing a CVP graph. A CVP graph highlights CVP relationships over
wide range of activity and can give managers a perspective that can be obtained in no other way.
How to Read the BEP Graph?
a) BEP- BEP is determined by the intersection of the total revenue line and the total expense line.
The company in our example breaks even at 25 units, or $ 5,000 of sales. This agrees with the
calculation made earlier.
b) Profit and loss area - The CVP graph discloses more information than the BEP calculation.
From the graph, a manager can see the effects on profits of changes in volume. The vertical distance
between the lines on the graph represents the profit and loss area at a particular sales volume. If sales are
fewer than 25 units, the organization will suffer a loss. The magnitude of the loss increases as sales
decline. The organization will have a profit if sales exceed 25 units a month.
c) Implications of the Breakeven Point - The position of the breakeven point within the
organization's relevant range of activity provides important information to management.
1.4 Target Profit Analysis
Managers can also use CVP analysis to determine the total sales, in units & dollars, needed to reach a
target profit.
Target sales - Variable costs - Fixed costs = Target NI.

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SPQ - VQ - FC = NI
Q (SP-VC) = NI + FC

Example: If Mary considers Br. 2,000 the minimum acceptable net income, how many units she must
sell?

= = 50 Units

If Mary wants to get a minimum NI of Br. 2000 she has to sell 50 units.

Target Sales volume in dollars = = = $ 10,000

Consideration of Income Tax under Target Profit Analysis

NI after tax = Operating Income - Income tax.
SPQ - VQ -FC = Target NI

Q (SP-V) = + FC

Example: Suppose Mary considers Br. 2400 minimum acceptable net income and pays an income and
pays an income tax of 40 %, how many units she must sell?

Target sale =

= = = 75 units

1.5 Margin of Safety:

It is the excess of expected sales over the breakeven volume of sales. It shows how far sales can fall
below the planned level before losses occur. Shows how far sales can fall below the planned level before
losses occur. It can be computed as follows:
Margin of Safety (MOS) = planned sales - BEP unit sales.
It can be expressed in ratio by dividing the MOS amount to the expected sales.
1.6 Sensitivity Analysis
Sensitivity analysis involves studying the effects of changes in variable costs, fixed costs, sales price,
and sales volume, on the company’s profitability.

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Per unit Percent of sale
Sales Price $250 100%
Less: Variable Exp. 150 60%
Contribution margin 100 40%
Total monthly fixed expenses = $35, 000
1) Change in fixed cost and sales volume
The company is currently selling 400 units per month (monthly sales of $100, 000). The sales manager
feels that a $10,000 increase in the monthly advertising budget would increase monthly sales by
$30,000. Should the advertising budget be increased?

Incremental cm ($30,000*40%) $12,000

Less: Incremental advertising Expense 10,000
Incremental Net Income 2,000
Assuming there are no other factors to be considered, the increase in the advertising budget should be
approved since it would lead to an increase in net income of $2,000.
2) Change in variable costs and sales volume
Refer back to the original data. Recall that the co. is currently selling 400 units per month. Management
is contemplating the use of high quality components, which would increase variable costs (and thereby
reduce the contribution margin) by $10 per unit. However, the sales manager predicts that the higher
overall quality would increase sales to 480 units per month. Should the higher quality components be
used?
The $10 increase in variable costs will cause the unit contribution margin to decrease from $100 to $90.

Expected total contribution margin with higher quality

Components: 480 units x $90 $43,200
Present total contribution margin: 400 units x $100 40,000
Increase in total contribution margin $ 3,200
Yes, based on the information above, the higher quality components should be used. Since fixed costs
will not change, net income should increase by the $3,200 increase in cm shown above.
3) Change in fixed cost, sales price, and sales volume
Refer to the original data and recall again that the company is currently selling 400 units per month. To
increase sales, the sales manager would like to cut the selling price by $20 per unit and increase the

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advertising budget by $15,000 per month. The sales manager argues that if these two steps are taken,
unit sales will increase by 50% to 600 units per month. Should the changes be made?
A decrease of $20 per unit in the selling price will cause the unit contribution margin to decrease from
$100 to $80.

Expected total contribution margin with lower selling price

600 units x $80 $48,000
Present total contribution margin: 400 units x $100 40,000
Incremental contribution margin 8,000
Less: Incremental fixed costs 15,000
Reduction in Net Income $ (7,000)
No, Based on the information above, the changes should not be made.
4) Change in variable cost, fixed cost, and sales volume
Refer to the original data. As before, the company is currently selling 400 units per month. The sales
manager would like to place the sales staff on commission basis of $15 per unit sold, rather than on flat
salaries that now total $6,000 per month. The sales manager is confident that the change will increase
monthly sales by 15% to 460 units per month. Should the change be made?

Changing the sales staff from a salaried basis to a commission basis will affect both fixed and variable
costs. Fixed costs will decrease by $6,000, from $35,000 to $29,000. Variable costs will increase by
$15, from $150 to $165, and the unit contribution margin will decrease from $100 to $85.

Expected total contribution margin with sales staff on

Commissions: 460 units x $85 $39, 100
Present total contribution margin: 400 units x $100 40, 000
Decrease in total contribution margin (9, 000)
Add: Salaries avoided if a commission is paid 6, 000
Increase in Net Income $ 5, 100
Yes, based on the information above, the changes should be made.
5) Change in regular sales price
Refer to the original data where the company is currently selling 400 units per month. The company has
an opportunity to make a bulk sale of 150 units to a wholesaler if an acceptable price can be worked out.
This would not disturb the company’s regular sales. What price per unit should be quoted to the
wholesaler if the company wants to increase its monthly profits by $3,000?
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Variable cost per unit $150

Desired profit per unit ($3, 000/150 units) 20
Quoted price per unit $170
Notice that no element of fixed cost is included in the computation. This is because fixed costs are not
affected y the bulk sale, so all of the additional revenue that is in excess of variable costs goes to
increasing the profits of the company.
1.7 CVP Analysis with Multiple Products
For any organization selling multiple products, the relative proportion of each type of product sold is
called the sales mix.
Sales mix - is the relative proportion or combinations of quantities of products that comprise
total sales. It is an important assumption in multi-product CVP analysis and is used to compute the
weighted average unit contribution margin.
Example: Suppose Mary intends to sell two soft ware products X & Y for the next convention &
budgets the following.
X Y Total
Units Sold. 60 40 100
Revenues, $200 $100 per unit $12,000 $ 4,000 $16,000
Variable Costs, $120 $70 per unit 7,200 2,800 10,000
Unit Contribution Margin, $80 $ 30 per unit $ 4,800 $ 1200 $ 6,000
Fixed Costs 4,500
Operating Income $ 1,500
Required: What is the BEP (in units & in Birr)? (Assume that the budgeted sales unit
3:2 is maintained i.e. It will not be changed at different level of total unit sales).

Weighted - Average Contribution Margin per unit =

= = = $ 60

OR the CM of each will be multiplied by its sales mix i.e.

(80*60%) + (30*40%) = $60

 BEP = = = 75, units. I.e. 60 % x 75 = 45 units of X

40 % X 75 = 30 units of Y
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 To Compute the BER (total revenues required to break even)

Weighted - Average CM % = = = 0.375 or 37.50%

 BER = = = $ 12,000

1.8 Assumptions and limitations of CVP analysis

For any CVP analysis to be valid, the following important assumptions must be satisfied with in the
relevant range:
 The total revenue line and the total expenses line must be straight line, i.e. the selling price
per unit, the variable cost per unit, and the total fixed cost must remain the same within the
relevant range.
 In multi-product companies, the sales mix remains constant over the relevant range.
 In manufacturing firms, number of units produced must equal with the number of units sold

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