Cost–volume–profit (CVP) analysis is a powerful tool that helps managers to understand the
relationships among cost, volume, and profit. CVP focuses on how profits are affected by the following
1. Prices of products.
2. Volume or level of activity.
3. Per unit variable costs.
4. Total fixed costs.
5. Mix of products sold.
- Helps mgers understand how profits are affected by these key factors
- Helps make decisions like what products to manufacturer, prices to charge, services to offer,
strategy to adopt, etc
The Basics of CVP analysis
- Contribution income statement emphasizes behaviour of costs and is therefore extremely
helpful to mger in judging the impact on profits of changes in selling price, cost, volume
- CMargin = Sales – Variable Expenses
- Operating income = CMargin – Fixed Expenses
- This contribution-format income statement was prepared for management's use inside the
company and would not ordinarily be made available to those outside the company.
- this statement reports sales, variable expenses, and contribution margin on both a per unit basis
and a total basis.
- Contribution margin (CM) is the amount remaining from sales revenue after variable expenses
have been deducted
- AMT avlbl to cover fixed expenses and provide profits for that period
- CM used first to cover fixed expenses, and then the remnants go towards PROFIT**
- If the contribution margin is not sufficient to cover the fixed expenses, then a loss occurs for the
- When enough sales are generated to generate amt enough to cover fixed costs, then co will
have managed to at last break even
- Break-even point is the level of sales at which profit is zero
- Once the break-even point has been reached, operating income will increase by the unit
contribution margin for each additional unit sold.
- To estimate profit at any sales level above the break-even point, simply multiply the number of
units sold in excess of the break-even point by the unit contribution margin
- Or, to estimate the effect of a planned increase in sales on profits, the manager can simply
multiply the increase in units sold by the unit contribution margin. o The result will be the expected increase in operating income.
- We assumed that selling price per unit, variable expenses per unit, and total fixed expenses
remained constant even for large changes in sales volumes.** - for simplicity
CVP relationships in graphic form
- Relationships among revenue, cost, profit, and volume can be expressed graphically by
preparing CVP graph
- Highlights CVP relationships over wide ranges of activity
- Called break-even chart; unit volume is X-axis, and dollars y-axis
- Three steps
o Draw line parallel to volume axis to represent total fixed expenses
o Choose any volume of sales and then using that plot TOTAL costs
After the point has been plotted, draw a line through it back to the point where
the fixed expenses line intersects the dollars axis.
o Again, chose some sales volume and plot point representing total SALES dollars; Draw a
line through this point back to the origin.
- Area in upper quadrant represents profit where revenue > expenses, and area below in left
quadrant represents loss; at the middle is BREAK-EVEN
- The break-even point is where the total revenue and total expenses lines intersect.
- When sales < this point = loss; when sales > this point = profit
- Loss becomes larger as sales decline
- Simpler form of the CVP graph (profit graph) is equation:
- This is a linear eqn, and plots profit as a single straight line
- To plot the line, must compute profit at two diff sales volumes (i.e. take 0, and 1) -
- Breakeven point on graph is volume of sales at which profit is zero and is indicated by the
dashed line on the graph
- Profit increases to the right of the breakeven (as sales increase) and decreases to the left of the
breakeven (as sales decrease)
Contribution Margin Ratio
- Adding the percentage of sales column to the contribution income statement
- The contribution margin expressed as a percentage of total sales is referred to as the
contribution margin (CM) ratio. This ratio is computed as follows:
- Shows how the contribution margin will be affected by a change in total sales
- Each dollar increase in sales will lead to (sales increase x CM ratio) increase in total contrib.
o Operating income will also increase by 40 cents, assuming that fixed costs are not
affected by the increase in sales
- The CM ratio is particularly valuable when trade-offs must be made between more dollar sales
of one product versus more dollar sales of another.
- Generally speaking, when trying to increase sales, products that yield the greatest amount of
contribution margin per dollar of sales should be emphasized. Some applications of CVP Concepts
Changes in fixed costs and sales volume
- Assuming no other factors need to be considered, the increase in the advertising budget should
be approved since it would lead to an increase in operating income
- Remember that WITH INCREASED SALES, VC will increase as well! - - so take the increase in
sales, divide by the price per unit and then multiply this by VC/unit to get the increase in
- REMEMBER that the advertising expense being incurred is a fixed cost, so the fixed costs must
increase as well (modified by the jump in FC)
Two alternative ways to show the same thing: - No need to know of previous sales; and unnecessary to prepare I/S; both approaches involve an
incremental analysis – consider only items of revenue, cost, and volume that will change if the
new program is implemented
- Incremental approach is more direct and focuses attention on the specific items involved in the
Change in VC and Sales Volume
- Sales increase by ____ units, but there is a corresponding increase in VC which means that CM
decreases (since CM = Sales – VC)
- Take the new sales and find CM now, compare with CM before (with old sales)
Change in FC, price, and volume
- Take the new sales x contribution margin – old sales x old CM = incremental CM
- Take incremental CM less increase in FC = operating income
Change in VC, FC, and Sales
- Salaries are fixed cost** - remember this
- So changing from salaries and making into commission will decrease FC, increase VC and since
CM = Sales – VC, it will also decrease CM
- The increase in VC is reflected as a decrease in CM – no need to account for both in this case
Change in regular selling price
- Co has chance to make bulk sale of 150
- Increase profit by 3k
- Calculate cost per speaker (3k / 150) = $20 (add this to regular VC) to get appropriate price
- By attempting to offset losses through a special order, a manager may quote such a high price
that the order will be lost.
- A manager must always keep such market considerations in mind when deciding on prices.
- Moreover, we assume that the bulk order will not affect sales to regular customers.
o Serious implications if this assumption doesn’t hold though
- Existing customers may find out about this order and demand the same low price, or they may
simply buy from competitors. - Also, the bulk sale could lead to more orders from this new customer so accepting a lower price
in the short-run may produce longer-term benefits through repeat sales.
- In summary, managers should consider both the short-term and long-term strategic
consequences of their decision before accepting or rejecting such opportunities
Importance of CM
- CVP analysis seeks the most profitable combination of variable costs, fixed costs, selling price,
and sales volume
- Effect on CM is a major consideration in deciding most profitable combination of these factors
- Profits can sometimes be improved by reducing contrib. margin if fixed costs can be reduced by
a > amount
- Way to improve profits is to increase the total contrib. margin*****
o This can be done by increasing FC and thereby increasing volume
o Or by trading off VC/FC with appropriate changes in volume
- The greater the unit contribution margin, the greater the amount the company may be willing to
spend in order to increase unit sales.
- This explains in part why companies with high unit contribution margins (such as auto
manufacturers) advertise so heavily, while companies with low unit contribution margins (such
as dishware manufacturers) tend to spend much less for advertising.
Break Even Analysis
- Answer questions such as how far s