Chapter Seven

Cost-Volume-Profit Analysis
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Learning Objectives

• Explain cost-volume-profit (CVP) analysis, the

CVP model, and the strategic role of CVP analysis

• Apply CVP analysis for breakeven planning

• Apply CVP analysis for profit planning

• Apply CVP analysis using activity-based costing

(ABC)

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2008
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Learning Objectives
(continued)

• Employ sensitivity analysis to more effectively use

CVP

• Adapt CVP analysis for multiple products

• Apply CVP analysis in not-for-profit organizations

• Identify the assumptions and limitations of CVP

analysis
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2008
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CVP Analysis

• CVP analysis is a method for analyzing how

operating decisions and marketing decisions
affect profit

• CVP relies on an understanding of the

relationship between variable costs, fixed
costs, unit selling price, and output level
(volume)

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2008
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CVP Analysis (continued)

CVP analysis can be used in:

– Setting prices for products and services
– Determining whether to introduce a new product or
service
– Replacing a piece of equipment
– Determining breakeven point
– Making “Make-or-buy” (i.e., sourcing) decisions
– Determining the best product mix
– Performing strategic “what-if” (sensitivity) analysis

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2008
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CVP Analysis (continued)

The CVP model is as follows:

Operating profit = Sales - Total costs

or
Sales = Fixed costs + Variable costs + Operating profit
or
(Units sold x unit sp) = Fixed costs + (Units sold x Unit v.c.) + Operating profit

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2008
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CVP Analysis (continued)

For convenience, the model is commonly shown in

symbolic form:

(p x Q) = F + (v x Q) + N

Where:
Q = units sold
p = unit selling price
F = total fixed cost
v = unit variable cost
N = operating profit
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2008
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CVP Analysis (continued)

Three additional concepts regarding the CVP model:

– Contribution margin:

• Unit contribution margin (cm) = Unit sales

price (p) – Unit variable cost (v)

• Unit contribution margin (cm) = the increase in operating

profit for a unit increase in sales = (p – v)

• Total contribution margin (CM) = Unit contribution

margin (cm) x Units sold (Q)

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2008
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CVP Analysis (continued)

– Contribution margin ratio = Unit contribution margin

(cm)/unit sales price (p)
= (p – v)/p = cm/p

– The contribution income statement:

• A useful way to show information developed in CVP
analysis
• Classifies costs based on cost behavior (fixed versus
variable) rather than cost type (product versus period)
• Provides an easy and accurate prediction of the effect of
a change in sales on profits
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2008
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Strategic Role of CVP Analysis

CVP analysis can help a firm choose its strategic

position and execute its strategy by providing an
understanding of how changes in sales volume affect
costs and profits

– This process is most important for cost leadership firms

during the manufacturing stage
– Differentiation firms use CVP analysis to assess profitability
and desirability of new products and features

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2008
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Strategic Role of CVP Analysis

(continued)
CVP analysis is also important in life-cycle costing
and target costing

– CVP analysis can assist in life-cycle costing by helping to

determine whether a product is likely to achieve its desired
profitability, the most cost-effective manufacturing process,
the best marketing and distribution channels, the best
compensation plan, whether to offer discounts, etc.
– CVP analysis can assist in target costing by showing the
effect on profit of alternative product designs that have
different target costs
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2008
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Breakeven (B/E) Planning

Determining the “breakeven point” is the starting
point of many business plans:
– Breakeven is the point at which revenues equal
total costs and profit is zero
– The breakeven (B/E) point can be determined in
either of two ways:
• Equation Method:

– Based on Units Sold (Q)

– Based on Sales Dollars ($)
• Contribution Margin Method:
– Based on units sold (Q)
– Based on sales dollars ($)
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2008
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B/E Planning (continued)

The Equation Methods (@ B/E, N = $0)

1) B/E in unit sales (Q = sales in units):

p x Q = (v x Q) + F + N
p x Q = (v x Q) + F

2) B/E in sales dollars (Y = sales in dollars) :

Y = [(v/p ) x Y ] + F + N
Y = [(v/p ) x Y ] + F
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2008
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B/E Planning (continued)

The Contribution Margin Methods

3) B/E in sales units (Q):

Q= F
p -v
4) B/E in sales dollars (Y):

Y= F
(p - v )/p

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2008
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Example: Breakeven Planning

Household Furnishings, Inc. (HFI) wants to perform a B/E analysis
given the following expected results for 2007 and 2008:
Per Unit 2007 2008
Fixed cost $60,000 $60,000
Revenue $75
Variable cost 35
Planned production 2,400 units 2,600 units
Planned Sales 2,400 units 2,600 units

Contribution Income Statement for HFI's Proposed TV Table

2007 2008
Amount Percent Amount Percent Change
Sales $180,000 100.00% $195,000 100.00% $15,000
Variable costs 84,000 46.67% 91,000 46.67% 7,000
Contribution margin $96,000 53.33% $104,000 53.33% $8,000
Fixed costs 60,000 60,000 0
Profit $36,000 $44,000 $8,000
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2008
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Breakeven Example (continued)

The Equation Methods

1) Breakeven in sales units (Q = sales in units)
p x Q = (v x Q) + F + N

Assume the management accountant is using the equation method

to analyze the breakeven point (in units) of HFI's sale of TV tables:

p x Q =( v x Q) + F + N
$75 x Q = ($35 x Q) + $5,000 + $0
($75 - $35) x Q = $5,000
Q = $5,000/($75 - $35)
Q = $5,000/$40 = 125 units per month

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2008
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Breakeven Example (continued)

The Equation Methods (Continued)

2) Breakeven in sales dollars (Y = sales in dollars)

Y = [(v/p ) x Y] + F + N

Assume the management accountant is using the equation method

to analyze the breakeven point (in sales dollars) of HFI's sale of TV tables
and he/she does not know the unit sales price or the unit variable costs:

Y = [(v/p ) x Y] + F + N
Y = [($84,000/$180,000) x Y] + $5,000 + $0
Y = [0.4667 x Y] + $5,000
Y = $9,375 per month

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies

2008
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Breakeven Example (continued)

The Contribution Margin Methods
3) Breakeven in sales units

Q=
F +N
p -v
Assume the management accountant is using
the contribution margin method to analyze the
breakeven point (in units) of HFI's sale of TV tables:
Q= F +N
p -v
Q= $5000 + $0
($75 - $35)
Q = 125 units per month
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2008
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Breakeven Example (continued)

The Contribution Margin Methods (continued):

4) Breakeven in sales dollars
Y= F +N
(p - v )/p

Assume the management accountant is using the

contribution margin method to analyze the breakeven
point (in sales dollars) of HFI's sale of TV tables
and he/she does not know the unit sales price or

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies

2008
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Breakeven Example (continued)

Y= F +N
(p - v )/p
Y = $5000 + $0
($75 - $35)/$75
Y = $5000 + $0
0.5333
Y= $9,375 per month
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2008
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CVP Graph and Profit-Volume (PV)

Graph
• The CVP graph illustrates how the levels of
revenues and total costs change as output
(sales volume) changes
– Sales below the breakeven point result in a loss for
the firm
• A profit-volume (PV) graph illustrates how the
level of operating profit changes as output
(sales volume) changes
– This graph allows a person to clearly see how total
contribution margin, and therefore profit, changes as
the output level (i.e., volume) changes
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2008
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CVP Graph and PV Graph (continued)

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2008
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CVP Analysis in Profit Planning

CVP analysis can be used to determine the sales
volume needed to achieve a desired level of profit:
For example, if HFI's management needs to know
the revenue required to achieve $48,000 in annual profits.....

Q = F +N
p -v
Q = $60,000 + $48,000
$75 - $35
Q = 2,700 units per year
In sales dollars the result is
p x Q = $75 x 2,700
p x Q = $202,500 per year
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies
2008
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CVP and Profit Planning (continued)

Assume that HIFI has the option to choose

between two machines that will complete the same
operation with the same quality, but with different
variable costs per unit (v) and different total fixed
costs (F). B/E analysis can help HIFI find the level
of sales (called the “indifference point”), such that
having sales > that this level will favor the option
with the higher fixed costs, and having sales < this
level will favor the other option.
Which alternative should be chosen?

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies

2008
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CVP and Profit Planning

(continued)

Cost of Machine A = Cost of Machine B

$5,000 + ($10 x Q) = $15,000 + ($5 x Q)

Q = $10,000/$5
Q = 2,000 units

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies

2008
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CVP and Profit Planning (continued)

Management decisions about costs and prices usually
must include income taxes because taxes affect the
amount of net profit at a given level of sales

In the HFI example, if we assume that the average income

tax rate is 20 percent, to achieve the desired annual after-tax
profit of $48,000, HFI must generate before-tax profits of ....

Before-tax profit = After-tax profit/(1 - Tax Rate)

Before-tax profit = $48,000/(1 - 0.2)

Before-tax profit = $60,000

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies
2008
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CVP and Profit Planning

(continued)

In the HFI example, if we assume that the average income

tax rate is 20 percent, to achieve the desired annual after-tax
profit of $48,000, HFI must generate before-tax profits of ....
Before-tax profit = After-tax profit/(1 - Tax Rate)
Before-tax profit = $48,000/(1 - 0.2)
Before-tax profit = $60,000

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2008
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CVP Analysis and

Activity-Based Costing (ABC)
The conventional approach to CVP analysis is to
use a volume-based measure to forecast costs, but
an ABC approach is also possible:
– If the assumption is made that total batch-level costs are
fixed relative to the number of batches, both approaches
will produce the same result
– On the other hand, if the activity cost pool is a mixed cost,
the ABC approach will provide a more accurate estimate
of cost because the volume-based approach treats all
activity costs that do not vary with output volume, such as
machine setup, materials handling, inspection, and
engineering, as fixed
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2008
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CVP Analysis and ABC (continued)

In the ABC approach, additional terms are needed to

define the fixed cost element (HFI’s results are in
parentheses below):

– ƒVB = the level of volume-based fixed costs, or the

portion of fixed costs that do not vary with the activity
cost driver ($50,000)
– ƒAB = the portion of fixed costs that do vary with the
activity cost driver ($10,000)
– vAB = the cost per batch for the ABC driver ($100)
– b = the number of units in a batch (30)
– vAB/b = the cost per unit of product for batch-related
costs when the batch is size b ($3.33)
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies
2008
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CVP Analysis and ABC (continued)

The CVP model under ABC is:

f VB + N
Q=
p – v – (vAB/b)
Therefore, output quantity for HFI is:

Q= $50,000 + $48,000 Q = 2,673 units or 89.1 (2,673/30) batches

$75 – $35 – ($100/30)
There are no partial batches so $9,000 (90 batches x $100 per batch)
must be figured into the equation

$50,000 + $9,000 + $48,000 Q = 2,675 units in 90 batches

Q=
$75 – $35
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2008
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Sensitivity Analysis and CVP

Sensitivity analysis is the name for a variety of methods
that examine how an amount (e.g., B/E point) changes if
factors involved in predicting that amount change (e.g.,
sales volume or unit variable cost).

For CVP, three methods of sensitivity analysis are

commonly employed:
(1) What-if analysis (using the contribution
margin and contribution margin ratio)
(2) The margin of safety (or, margin of safety
ratio), and
(3) The degree of operating leverage
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2008
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Sensitivity Analysis and CVP

(continued)

What-if analysis is the calculation of an amount

given different levels of a factor that influences
that amount
– Example: if contribution margin (cm) is $40 per unit
and the cm ratio is 0.53333, each unit change in
sales volume affects profit by $40 and each dollar
change in sales affects profits by $0.53333

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2008
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Sensitivity Analysis (continued)

Margin of safety is the $ amount of sales above the

B/E point (i.e., forecasted sales level minus the B/E
sales level)

– Margin of safety can also be used as a ratio

– The margin of safety ratio is the margin of safety divided

by planned sales

– This ratio is a useful measure for assessing risk

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies

2008
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Sensitivity Analysis (continued)

Degree of operating leverage (DOL) is the ratio of CM

to operating profit:

– A higher DOL value indicates a higher risk in the sense

that a given change in sales will have a relatively greater
% impact on profits
– The DOL can be thought of as the extent to which fixed
costs characterize the cost structure of an organization:
the higher the percentage of fixed costs, the higher the
DOL (and therefore the higher the operating risk)

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2008
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Sensitivity Analysis (continued)

–The DOL is defined at each sales volume level

– Organizations with high DOL work hard for even small %
increases in sales volume (because these changes are
magnified as % changes in operating profit)

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2008
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Multi-Product CVP Analysis

• If all fixed costs are traceable to individual products,
then the organization can develop a separate CVP
model for each product
• Alternatively, the multi-product firm can make an
assumption regarding a standard sales mix in which its
products are sold
• Sales mix can be determined on the basis of sales
dollars or unit sales

• The assumption of sales mix allows the firm to

calculate and use a weighted-average contribution
margin (cm) per unit and weighted average cm ratio to
do multi-product CVP analysis
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies
2008
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Example: Multi-Product CVP Analysis

Windbreakers, Inc. sells light-weight sports/recreational
jackets and currently has three products: Calm, Windy, and
Gale. Total (joint) fixed costs for the period are expected to be
$168,000, and we assume the windbreakers’ sales mix,
measured by sales dollars, will remain constant. Additional
information is provided below.
Calm Windy Gale Total
Last period's sales $ 750,000 $ 600,000 $ 150,000 $ 1,500,000
Percent of sales 50% 40% 10% 100%
Price $ 30 $ 32 $ 40
Unit variable cost 24 24 36
Contribution margin $ 6 $ 8 $ 4
Contribution margin ratio 20% 25% 10%

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies

2008
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Example: Multi-Product CVP (continued)

From this information, we can calculate the wtd. avg. cm ratio:
Weighted-average CMR = 0.5(0.2) + 0.4(0.25) + 0.1(0.1) = 0.21
The breakeven point for all three products can be calculated
as follows:
Y = 168,000/0.21
Y= $800,000
This means that for Windbreakers to break even, $800,000 of all three
products must be sold in the same proportion as last year's sales mix.
The sales for each product need to be as follows:
For Calm 0.5($800,000) = $400,000
For Windy 0.4($800,000) = 320,000
For Gale 0.1($800,000) = 80,000
$800,000
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies
2008
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Assumptions of CVP Analysis

CVP analysis has its limitations as it relies on

assumptions:

– Linearity and the relevant range:

• The CVP model assumes revenues and costs are
linear over a “relevant range” (even though the actual
cost behavior may not be linear)
• Outside the relevant range, these calculations will not
be accurate
• Step costs also make approximation via the relevant
range unworkable; CVP analysis becomes much more
cumbersome
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies
2008
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Assumptions of CVP Analysis

(continued)

– Identifying fixed and variable costs: there are

several issues

• Which fixed costs should be included?

• Should fixed costs be accounted for using the cash

or accrual method?
• Have all relevant unit variable costs been included
(production, selling, distribution, etc.)?

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies

2008
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Chapter Summary

• CVP analysis is a method for analyzing how operating

and marketing decisions affect profit

• CVP analysis depicts the relationship between

variable costs, fixed costs, unit selling price, and
output level (volume)

• CVP analysis can help a firm choose its strategic

position and execute its strategy by providing an
understanding of how changes in its volume of sales
affect costs and profits

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies

2008
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Chapter Summary (continued)

The breakeven (B/E) point is the starting point of many
business plans:
– B/E is the point at which total revenues equal total costs, i.e.,
point of sales at which operating profit is zero
– The B/E point can also be defined as the sales level at which
CM = FC
– There are two methods, equation and contribution margin,
that can be used for profit-planning (i.e., CVP analysis)
purposes
• In each method, sales volume can be expressed either on
the basis of units or dollars
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies
2008
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Chapter Summary (continued)

• CVP analysis can be used to determine the level of

sales needed to achieve a desired level of profit
through revenue planning, cost planning, and
accounting for the effect of income taxes

• The conventional approach to CVP analysis is to use

a volume-based measure, but an activity-based
costing (ABC) approach to CVP analysis is also
possible

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies

2008
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Chapter Summary (continued)

• Sensitivity analysis is the name for a variety of methods

that examine how an amount changes if factors involved
in predicting that amount change

• This chapter covered three forms of sensitivity analysis:

– “What-if” analysis using the cm or the cm ratio

– The margin of safety, and

– Degree of operating leverage (DOL)

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies

2008
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Chapter Summary (continued)

CVP analysis can be used in the multi-product case, but

it is often impractical to apply CVP analysis separately
for each product

– The existence of joint/common (i.e., non-traceable) fixed

costs complicates short-run profit planning through CVP
analysis

– If the firm is willing to assume that its mix (either in dollars

or in units) remains constant as volume changes, then it
can calculate and use for profit-planning purposes a
weighted-average cm per unit and a weighted-average cm
ratio
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies
2008
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Chapter Summary (continued)

– The weighted-average cm per unit allows a multi-product

firm to calculate the B/E sales volume in UNITS; this total
B/E sales volume can then be allocated to products
using the sales-mix percentages based on units

– The weighted-average cm ratio allows a multi-product

firm to calculated the B/E sales volume in DOLLARS;
this total B/E sales volume can then be allocated to
products using the sales-mix percentages based on
sales dollars

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies

2008
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Chapter Summary (continued)

CVP analysis relies for its validity on a number of

assumptions:
– For conventional CVP analysis, volume of sales (units) is
the only important cost driver

– Costs, but variable and fixed, are linear within the relevant
range of output

– The revenue function is linear within the relevant range

(i.e., the firm’s marginal sales revenue is constant)

Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies

2008
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Chapter Summary (continued)

– Total costs can be reliably split into fixed and variable

components

– The underlying profit-planning model is deterministic (i.e.,

the inputs in the CVP model are known with certainty; for
this purpose, conventional CVP uses point estimates for the
factors in the model)

– For the multi-product firm, either fixed costs can be traced

(or reliably allocated) to individual products OR the firm’s
products are sold in a constant sales-mix (expressed either
in dollars or units)
Blocher,Stout,Cokins,Chen, Cost Management 4e ©The McGraw-Hill Companies
2008