Chapter

Introduction
3 Cost–Volume–Profit Analysis

Cost– volume–profit (CVP) analysis to study the behavior of and relationship among these
elements as changes occur in the number of units sold the selling price, the variable cost per unit,
or the fixed costs of a product.
CVP analysis focuses on how profits are affected by the following five factors:
a) Selling price b) Sales volume
c) Unit variable costs d) Total fixed costs
e) Mix of products sold
CVP analysis helps managers understand how profits are affected by these key factors, it is a
vital tool in many business decisions. These decisions include what products and services to
offer, what prices to charge, what marketing strategy to use, and what cost structure to
implement.
Contribution Margin
The only numbers that change from selling different quantities of packages are total revenues
and total variable costs. The difference between total revenues and total variable costs is called
contribution margin. CM per Unit =Price per unit -Variable Cost per Unit
Total CM= (Price x Quantity) - (Variable Cost x Quantity)
Profit Equation
Operating profit = Total revenues -Total costs
Profit = TR – TC = PX – VX – F π =(P – V)X – F Profit( π) = operating profit
TR = total revenue TC = total costs P = average unit selling price V = average unit
variable cost X = quantity of units F = total fixed costs for the period
Example
Sales price per unit $ 40
Variable costs per unit $16
Fixed costs $10,000 per month
Required
What is the operating profit of 500 units for the month?
Solution
Profit= (P – V) X – F =[(40-16) (500)] -$10,000 =$12,000-$10,000 =$2000

Contribution margin
Contribution margin percentage (or contribution margin ratio) =
Revenue
24
0.6 or 60%
40
Breakeven Point and Target Operating Income
Break-even is the point at which profit equals zero. At break-even, all fixed costs are covered,
but the firm is not producing any operating profit. Managers might want to know the break-even
point expressed either in units or in sales dollars.
Managers and entrepreneurs like Emma always want to know how much they must sell to earn a
given amount of income. Equally important, they want to know how much they must sell to
avoid a loss.
Breakeven Point
The breakeven point (BEP) is that quantity of output sold at which total revenues equal total costs—that is, the
quantity of output sold that results in $0 of operating income.

¿Cost
Break-even point (units) =
Unit Contrabution Margin
¿ Cost
Break-even point (dollars) =
Contrabution Margin Ratio
Target Profit Analysis

One of the key uses of CVP analysis is called target profit analysis. In target profit analysis, we
estimate what sales volume is needed to achieve a specific target profit.
The target profit analysis is determined by:
1. Equation Method which is a basic profit equation to find the sales volume required to attain a
target profit.
Profit t = Unit CM × Q- Fixed cost
¿ Cost +Target Profit
Target volume (units) =
Unit Contrabution Margin

¿ Cost + Target Profit

Target volume (Dollars) =
Contrabution Margin Ratio

Margin of Safety
The margin of safety is the excess of budgeted (or actual) sales dollars over the breakeven
volume of sales dollars. It is the amount by which sales can drop before losses are incurred. The
excess of the projected or actual sales volume over the breakeven volume expressed as a
percentage of actual sales volume is the margin of safety percentage.
Margin of safety =Total budgeted Sales −Break-even sales

Example:
Fatah Manufacturing Company reported $4,000,000 of sales during the month and incurred
variable expenses totaling $2,800,000 and fixed expenses of $720,000. A total of 80,000 units
were produced and sold last month. The company has no beginning or ending inventories.
a) What is the company’s total contribution margin and contribution margin per unit?
b) How many units would the company have to sell to achieve a desired target profit of
$600,000?
c. What is the company’s break-even point in sales dollars?
d. What is the company’s margin of safety?

Solution

a. Total contribution margin = Sales – Variable expenses

Total CM = $4,000,000 – $2,800,000 = $1,200,000
CM per unit =Total contribution margin / Number of units
CM per unit =$1,200,000 /80,000 units = $15
b. Required units to be sold = (Fixed cost + Desired targeted profit) ÷ CM per unit
Required units to be sold = ($720,000 + $600,000) ÷ $15 per unit = 88,000 units
c. Break-even point in sales dollars = Fixed expenses ÷ CM ratio
Break-even point in sales dollars = $720,000 ÷ 30% = $2,400,000
d. Margin of safety = Total sales – Break-even sales
Margin of safety = $4,000,000 – $2,400,000 = $1,600,000

Contribution Margin versus Gross Margin

So far, we have developed two important concepts relating to profit margin—contribution
margin, which was introduced in this chapter, and gross margin, which was discussed in Chapter
2. Is there a relationship between these two concepts? In the following equations, we clearly
distinguish contribution margin, which provides information for CVP analysis, from gross
margin, a measure of competitiveness, described in Chapter 2.
Gross margin = Revenues - Cost of goods sold
Contribution margin = Revenues - All variable costs
Sales Mix
The term sales mix refers to the relative proportions in which a company’s products are sold.
The idea is to achieve the combination, or mix, that will yield the greatest amount of profits.
Most companies have many products, and often these products are not equally profitable. Hence,
profits will depend to some extent on the company’s sales
mix. Profits will be greater if high-margin rather than low-margin items make up a relatively
large proportion of total sales.
Managers often assume a particular product mix and compute break even or target volumes using
either of two methods and these methods which give the same result.
1. Fixed product mix
2. Weighted average contribution margin
Questions

3-1 Define cost–volume–profit analysis.

3-2 Distinguish between operating income and net income.
3-3 Define contribution margin, contribution margin per unit, and contribution margin
percentage.
3-4 Describe three methods that managers can use to express CVP relationships.
3-5Why is it more accurate to describe the subject matter of this chapter as CVP analysis rather
than as breakeven analysis?

Exercises 1

Lucido Products markets two computer games: Claimjumper and Makeover. A

contribution format income statement for a recent month for the two games appears on
the following page:

Required:
1. Compute the overall contribution margin (CM) ratio for the company.
2. Compute the overall break-even point for the company in sales dollars.
3. Verify the overall break-even point for the company by constructing a contribution format
income statement showing the appropriate levels of sales for the two products.

Exercises 2

CVP computations. Garrett Manufacturing sold 410,000 units of its product for $68 per unit in
2014.
Variable cost per unit is $60, and total fixed costs are $1,640,000.
1. Calculate (a) contribution margin and (b) operating income.
2. Garrett’s current manufacturing process is labor intensive. Kate Schoenen, Garrett’s
production manager, has proposed investing in state-of-the-art manufacturing equipment, which
will increase the annual fixed costs to $5,330,000. The variable costs are expected to decrease to
$54 per unit. Garrett expects to maintain the same sales volume and selling price next year. How
would acceptance of
Schoenen’s proposal affect your answers to (a) and (b) in requirement 1?
3. Should Garrett accept Schoenen’s proposal? Explain.