CHAPTER 3

Cost-Volume-Profit Analysis

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E A R S O N Prentice
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I G H T S R E S E RV E D .

WHY USE CVP?

CVP is a planning tool
Inputs to CVP model are costs, volume and price
Output is projected operating income
Use varies, but includes:

Budgeting. Given target operating income, identifies required

combination of cost, volume and price.

Gauging the health of the company across time (CM, MOS, DOL)

Performing sensitivity analysis

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OVERVIEW OF REQUIRED
CALCULATIONS
CVP model 5 lines (Sales, VC, CM, FC, OI), 3 columns (Total,

unit, %)
Target operating income, including breakeven

Sales VC FC = OI

Tax effects

sensitivity analysis

multi-product companies

multiple cost drivers

Calculate margin of safety

(MOS = Current revenues or units BE revenues or units)

Degree of operating leverage

(DOL = CM/OI)

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THE FIVE-STEP DECISION-MAKING

PROCESS REVISITED
1.

Identify the problem and uncertainties

2.

Obtain information

3.

Make predictions about the future

4.

Make decisions by choosing between alternatives (using

CVP analysis!!)

5.

Implement the decision, evaluate performance, and learn

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CVP ASSUMPTIONS
Changes in sales volume are the sole cause of revenue/cost

changes
Fixed costs + Variable costs = Total costs
Revenue and costs have linear functions
Selling price, variable cost/unit and fixed costs are all known

and constant
Analysis is often for a single product. With multiple products,
the relative sales proportions are known and constant
Time value of money is ignored

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BASIC FORMULA
Revenue VC - FC = Operating Inc.
Where:
Revenue = Selling Price x Quantity
Sold
and
Variable costs = Variable cost/unit x
Quantity Sold

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CVP: CONTRIBUTION MARGIN

Contribution Margin
An extremely important and powerful tool used extensively
by Cost Accountants
Sales Variable Costs = Contribution Margin
Expressed on a unit basis:
SPu Vcu= CMu
E.g., $10 - $4 = $6

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CONTRIBUTION MARGIN
Contribution Margin = unit contribution margin x units

sold (Q)
CM = CMu x Q
Contribution Margin Ratio (%) = unit contribution margin /

sales price
CMR = CMu SPu

CM Ratio

Gives % of sales available to pay

fixed costs

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PROFIT PLANNING
Calculate the number of units that must be sold to achieve
target OI.
Sales VC FC = OI, and Sales VC = CM
Total

So, CM = FC + OI
Q * CMu = FC + OI

Sales

Q = (FC + OI)

VC

CMu
Ex., Q = (140 + 0) / 28
Q=5

CM

Unit

$
200

$
40

60
$
140

12
$
28

%
100%
30%
70%

Setting OI equal to FC
zero and solving
140for Q gives breakeven in units.

Breakeven point is a special case of

OI profit where OI is set to zero.
target

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DERIVATIONS BREAKEVEN IN
DOLLARS
Calculate the dollar sales value required to achieve target
OI:
Sales VC FC = OI, where VC = (0.3 x Sales)
Sales 0.3Sales FC = OI
Set OI to zero
Sales 0.3Sales FC = 0
CM

0.7Sales = $140
Sales = $200 at breakeven point

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PRACTICE
LSB Co. has the following income statement. If LSBs sales increase by $20,000,
what will be the companys operating income?

A.
B.
C.
D.

$42,000
$12,000
$50,000
$30,000

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CVP: GRAPHICALLY

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INCOME TAXES
Total
Sales
VC
CM
FC
OI

$
486
146
$
340

OI x (1 - tax rate)
= $140 NOI (after tax)

140
$
200
OI x 30% tax rate
= $60 tax

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INCOME TAXES
Total
Sales
VC
CM
FC
OI
Tax
(30%)
NOI

$
486
146
$
340
140
$
200

OI x 30% tax rate

= $60 tax
OI x (1 - tax rate)
= $140 NOI (after tax)

60
$
140

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INCOME TAXES
Total
Sales
VC
CM
FC
OI
Tax
(30%)
NOI

$
486
146
$
340
140
$
200

OI = $200
100%

NOI = $140
70%

OI x (1 tax rate) = NOI

OI x 70% = NOI
OI = NOI / 70%

60
$
140

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INCOME TAXES
Total
Sales
VC
CM

Unit
$
54
16
$
38

%
Ex., What is the
100% amount of sales
required to net
30% $140 after taxes?
70%

FC

140
OI Calculate OI = NOI / (1 tax rate); OI = $140/70% = $200
Tax Now apply the CVP formula: Sales VC FC = OI
CM - $140 = $200
(30%)

CM = $340
$
CM = Sales x 70%
NOI
140
CM / 70% = Sales
$340 / 70% = $486
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SENSITIVITY ANALYSIS
CVP is used to explore what-if scenarios
Selling price changes
Volume changes
Cost structure changes
Variable cost per unit changes
Fixed cost changes

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SENSITIVITY ANALYSIS, ILLUSTRATED

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MARGIN OF SAFETY (MOS)

Measures the distance between budgeted and breakeven
sales:
MOS = $Budgeted Sales $BE Sales

MOS Ratio
MOS Ratio = MOS Budgeted Sales
Removes size from analysis

MOS is used as one measure of risk

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OPERATING LEVERAGE
OL = CM / Net operating income
Measures how a % change in sales will affect profits
Higher OL means more fixed costs
Higher OL means riskier cost structure
OL is dynamic; decreases as company moves away from the

BEP

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OPERATING LEVERAGE, CONTD

. . . Measures how a % change in sales will affect profits
OL = CM / OI
New
OL = $350 / $210
Total
Total
OL = 1.7
Sales
$
500 $
525
VC
150
158
CM
$
350 $
368
FC
140
140
OI
$
210 $
228

How will a 5% increase in sales affect OI?

A 5% increase in sales = a 5% (1.7) = 8.5% increase in profits.
Verify: $500 * 1.05 = $525;
$210 * 1.085 = $228

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EFFECTS OF SALES-MIX ON CVP

Typical analyses involve multiple products sold, with

different volumes and costs

Use average CM for bundles of products.
Recall that relative sales proportions must be known and

constant

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MULTIPLE COST DRIVERS

A separate variable cost is calculated for each driver.
Examples include:

Customer or patient count

Passenger miles

Patient days

Student credit-hours

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ALTERNATIVE INCOME STATEMENT

FORMATS

Gross

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