JIGJIGA UNIVERSITY

COLLEGE OF BUSINESS AND

ECONOMICS DEPARTMENT OF
ACCOUNTING AND FINANCE

Presented by: Abdifatah

Sheikh Hasan
(Msc in ACFN )
 Chapter-1-Cost-Volume-Profit Relationships
 After studying Chapter -1, you should be able to:
 Explain how changes in activity affect contribution
margin and net operating income.
 Prepare and interpret a cost volume-profit (CVP) graph
and a profit graph.
 Use the contribution margin ratio (CM ratio) to
compute changes in contribution margin and net
operating income resulting from changes in sales
volume.
 Show the effects on net operating income of changes in
variable costs, fixed costs, selling price, and volume.
 Determine the level of sales needed to achieve a
desired target profit.
 Determine the break-even point
Cost volume profit relationships
Variable and Absorption Costing
Variable costing:- only those manufacturing
costs that vary with output are treated as
product costs. This would usually include
direct materials, direct labor, and the variable
portion of manufacturing overhead. Fixed
manufacturing overhead is not treated as a
product cost under this method. Rather, fixed
manufacturing overhead is treated as a
period cost
Continues…..
Absorption Costing:- treats all manufacturing
costs as product costs, regardless of whether
they are variable or fixed. The cost of a unit of
product under the absorption costing method
consists of direct materials, direct labor, and
both variable and fixed manufacturing
overhead. Thus, absorption costing allocates a
portion of fixed
Cost-volume-profit (CVP) analysis is a powerful
tool that helps managers understand the
relationships among cost, volume, and profit.
CVP analysis focuses on how profits are affected
by the following five factors
 Sales volume.
 Unit variable costs.
 Total fixed costs.
 Mix of products sold
 Selling price
CVP analysis helps managers to make following
important decision on
 what products and services to offer,
 what prices to charge,
 what marketing strategy to use, and

Cost volume profit analysis assumption
 Selling price is constant: the price of product or
service will not change as volume changes
 Costs are linear and can be accurately divided
into variable and fixed element the variable
element in constant per unit and the fixed
element is constant in total over the inter
relevant range
 The multi product companies the mix product
sold is remain constant
1.1.cost behavior analysis
Variable Costs: - are costs that vary in total directly and
proportionately with changes in the activity level. If the level
increases 10%, total variable costs will increase 10%. If the level
of activity decreases by 25%, variable costs will decrease 25%.
Example: direct materials, and direct labor for a manufacturer;
cost of goods sold, sales commissions, and freight-out for a
merchandiser. Etc
Fixed Costs: - Fixed costs are costs that remain the same in
total regardless of changes in the activity level
Example: property taxes, insurance, rent, supervisory salaries,
and depreciation on buildings and equipment, cleaning cost
Continue…….
Relevant Range:- The range over which a company
expects to operate during a year is called the relevant
range of the activity
Mixed Costs: - are costs that contain both a variable
element and a fixed element. Mixed costs, therefore,
change in total but not proportionately with changes in
the activity level.
Contribution margin (CM) is the amount of revenue
remaining after deducting variable costs. It is often
stated both as a total amount and on a per unit basis
Assume that local rental terms for a truck, including
insurance, are $50 per day plus 50 cents per mile. When
determining the cost of a one-day rental, the per-day
charge is a fixed cost (with respect to miles driven),
while the mileage charge is a variable cost.
 1.2. Cost-Volume-Profit Analysis
Cost-volume-profit:- (CVP) analysis is the study of the effects
of changes in costs and volume on a company’s profits. CVP
analysis is important in profit planning. It also is a critical
factor in such management decisions as setting selling prices,
determining product mix, and maximizing use of production
facilities.
 To illustrate a CVP income statement, let's consider Alpha
Video Company. Alpha Video produces a high-definition digital
video camera. Relevant data for the video cameras sold by this
company in June 2021 are as follows.
 Assumed selling and cost data for Alpha Video Company
 Unit selling price of video camera ………….$500
 Unit variable costs …………………………………$300
 Total monthly fixed costs……………………….$200,000
 Units sold………………………………………………1,500 video
cameras
Required
 prepare cost volume profit/contribution margin income
statement?
Contribution Margin
 The contribution marginRatio
ratio:- is the contribution
margin per unit divided by the unit selling price. For
Alpha Video, the ratio is as follows.
Contribution Margin Ratio = Contribution Margin per
Unit divided by Unit Selling Price 40% = $200 /$500
The contribution margin ratio of 40% means that $0.40
of each sales dollar ($1x40%) is available to apply to
fixed costs and to contribute to net income. This
expression of contribution
Margin is very helpful in determining the effect of
changes in sales on net income. For example, if sales
increase $100,000, net income will increase $40,000
(40% x $100,000). Thus, by using the contribution
margin ratio, managers can quickly determine increases
in net income from any change in sales.
Class work
Let's see this effect changes in sales
through a CVP income statement.
Assume that Alpha Video’s current
sales are $500,000 and it wants to
know the effect of a $100,000 (200-
unit) increase in sales. Alpha
prepares a comparative CVP income
statement analysis as follows.
 Break-Even points
Break even point:- is the point at
which total revenue is exactly equal
to total cost. Where the company
have no profit and losses
A key relationship in CVP analysis is
the level of activity at which total
revenues equal total costs (both fixed
and variable). This level of activity is
called the break-even point
The process of finding the break-
even point is called break-even
Break-Even Analysis
Break-even analysis can be approached in three
ways:
1. Graphical analysis.
2. Equation method.
3. Contribution margin method.
Mathematical Equation
Sales = Variable Costs + Fixed Costs +Net Income
 Identifying the break-even point is a special case
of CVP analysis. Because at the break-even point
net income is zero, break-even occurs where
total sales equal variable costs plus fixed costs.
We can compute the break-even point in units
directly from the equation by using unit selling
prices and unit variable costs. The computation
for Alpha Video is:
Sales = Variable Costs + Fixed Costs + Net
Income
$500Q = $300 Q+ $200,000 +$0
$200Q = $200,000
Q = 1,000 video cameras
Break even point in term dollar
Break even point in dollars equals your
total fixed costs for particular period
divided by contribution margin ratio.
Break-even Point in Units = Fixed Costs ¸
Contribution Margin per Unit
Class work
 compute break even point in terms
of dollars
Based on our previous given
examples ?
 Planning With Cost-Volume-Profit Data
CVP analysis can be used to determine the
level of sales needed to achieve a desired
level of profit. Finding the desired profit
involves revenue planning, cost planning,
and accounting for the effect of income
taxes (when planning for the desired profit
after-tax).
 Target Net Income:-It indicates the
sales necessary to achieve a specified level
of income. Companies determine the sales
necessary to achieve target net income by
using one of the three approaches
discussed earlier
Mathematical Equation
We know that at the break-even
point no profit or loss results for the
company. By adding an amount for
target net income to the same basic
equation, we obtain the following
formula for determining required
sales.
Required Sales (in Units) =
Variable Costs + Fixed Costs +
Target Net Income
Example
Assuming that target net income is
$120,000 for Alpha Video, the
computation of required sales in
units is as follows.
Required Sales (in Units) =
Variable Costs + Fixed Costs +
Target Net Income
$500Q = $300Q + $200,000 +
$120,000
 Contribution Margin Technique
As in the case of break-even sales, we
can compute in either units or dollars,
the sales required to meet a target net
income. The formula to compute
required sales in units for Alpha Video
using the contribution margin per unit is
as follows.
Required Sales (in Q)=Fixed Costs +
Target NI
Contribution Margin
per Unit
 Q = ($200,000 +
$120,000)/$200
Q = ($320,000)/$200
Q = 160,000 video cameras
Sensitivity Analysis of CVP Results
CVP analysis becomes an
important strategic tool when
managers use it to determine
the sensitivity of profits to
possible changes in costs or
sales volume. If costs, prices,
or volumes can change
significantly, the firm’s strategy
might also have to change.
CONTINUES ………
Sensitivity analysis is the name
for a variety of methods that
examine how an amount changes if
factors involved in predicting that
amount change. Sensitivity
analysis is particularly important
when a great deal of uncertainty
exists about the potential level of
future sales volumes, prices, or
CONTINUES ………
For example, if there is a risk
that sales levels will fall below
projected levels, management
would be prudent to reduce
planned investments in fixed
costs (i.e., investments to
increase production capacity).
common methods for sensitivity analysis
1. what-if analysis using the
contribution margin and
contribution margin ratio
2. the margin of safety,
3.operating leverage.
1. What-if analysis
What-if analysis is the calculation of an
amount given different levels for a factor that
influences that amount. It is a common
approach to sensitivity analysis when
uncertainty is present. Many times it is based
on the contribution margin and the
contribution margin ratio. For example, the
contribution margin ($40) and contribution
margin ratio (0.5333) for Global Company
provide a direct measure of the sensitivity of
Global Company’s profits to changes in
volume.
continues
An example of a data table for Global
Company is shown below; units sold,
fixed cost, and price are held
constant, and we examine the effect
of changes in unit variable cost on
profits.
Units Sold Unit VC FC Price Profit
1,500 $30 $60,000 $75 $7,500
1,500 35 60,000 75 $0
1,500 40 60,000 75 ($7,500)
1,500 45 60,000 75 ($15,000)
2. Margin of Safety
Margin of Safety - the margin of safety
is the excess of an organization’s
expected future sales (in either
revenue or units) above the breakeven
point. The margin of safety indicates
the amount by which sales could drop
before profits reach the breakeven
point:
 Example
To illustrate assume that White
Company plans to sell 1,000 units
at $400 each in the coming year.
White has variable costs of $325
and fixed costs of $45,000.
 Break-even units = F/ (p - v)
Break-even units = $45,000/ ($400
- $325) = 600 units
Break-even revenues = 600 units x
$400 = $240,000
Required:
Calculate the margin of safety for
White in terms of the number of units.
Calculate the margin of safety for
White in terms of sales revenue.
Calculate the margin of safety
percentage for White in terms of the
number of units.
Calculate the margin of safety
percentage for White in terms of sales
revenue.
Calculation:
(a) Margin of safety in units = 1,000
units - 600 units = 400 units
(b) Margin of safety in sales revenue
= $400(1,000) - $400(600) =
$160,000
©Margin of safety percentage in
units = 400 units/1,000 units = 0.4
=40%
(d)Margin of safety percentage in
revenues = $160,000/$400,000 = 0.4
3. Degree of Operating Leverage
A lever:- is a tool for multiplying force. Using
a lever, a massive object can be moved with
only a modest amount of force. In business,
operating leverage serves a similar purpose.
Operating leverage:- is a measure of how
sensitive net operating income is to a given
percentage change in dollar sales.
Operating leverage acts as a multiplier. If
operating leverage is high, a small
percentage increase in sales can produce a
much larger percentage increase in net
operating income
Degree of operating leverage = Contribution
margin
Net
operating income
END OF CHAPTER ONE

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