Cost-Volume-Profits Analysis

Overview

Definition
Direct Costing Approach
Cost-Volume-Profits (CVP) Analysis

Single-Product CVP Analysis

Multiple-Products CVP Analysis

Graphical Representation
Assumptions of CVP Analysis
Nonlinear CVP Analysis
Other Applications

Cost-Volume-Profits Analysis

A planning tool for analyzing the

relationship among costs, sales
volume and profits.

Cost-Volume-Profits Analysis

Full Costing

product cost = DM + DL + var OH + fixed OH

Direct Costing
(Contribution Margin Approach)

product cost = DM + DL + var OH

Class Example
Contribution Margin Analysis
Products

Price

$20

$30

$25

$6

$12

$17

$14

$18

$8

CM ratio

70%

60%

32%

Direct Materials (kgs.)

5 kg.

3 kg.

1 kg.

Variable Costs
Contribution Margin (CM)

Direct labour (DLH)

2 DLH

5 DLH 4 DLH

Class Example
Contribution Margin Analysis
Required:
1. Sales constraint:
no
Production constraint: 100,000 kgs. of direct materials
2.

Sales constraint:

A10,000 units;
B15,000 units;
C40,000 units;
Production constraint: 100,000 kgs. of direct materials

3.

Sales constraint:
no
Production constraint:
100,000 kgs. of direct materials
80,000 DLH

Direct Costing Approach

Profits = Revenue Variable costs Fixed costs
Z
= px vx FC
where
Z
= profits
p
= selling price
v
= variable cost per unit
FC = total fixed costs
x
= sales units

Cost-Volume-Profits
(CVP) Analysis

Single product

Multiple products

Single Product CVP Analysis

1.

Sales required to achieve a before-tax

profit target, Z*
Z* = px* - vx* - FC
= (p-v)x* - FC
FC + Z* = (p-v)x*
*
FC
+
Z
*
x =
p-v

Single-Product CVP Analysis

Sales required, S* ($) = p x*
*
FC
+
Z
S* ($) = p p-v
*
FC
+
Z
S* ($) =
(p-v)/p

Single Product CVP Analysis

1.

Sales required to achieve a before-tax

profit target, Z*
Sales required, x* =

Fixed costs + before- tax profit target

contribution margin per unit
Sales required, S* =
Fixed costs + before- tax profit target
contribution margin ratio

Single Product CVP Analysis

2.

Sales required to achieve an after-tax profit

target, Z*a

After-tax profit target

= Before-tax profit target - tax

= Before-tax profit target x (1 - tax rate)
Before-tax profit target
= After-tax profit target
1 - tax rate

Single Product CVP Analysis

2.

Sales required to achieve an after-tax profit

target, Z*a
*
Z
a
FC
+
1-t
x*a =
t = tax rate
p-v

Sales required, x*a =

After-tax profit target

Fixed costs +
1 tax rate
contribution margin per unit

Single Product CVP Analysis

2.

Sales required to achieve an after-tax profit

target, Z*a
Sales required, S*a ($)=
Before-tax profit target
Fixed costs +
1 tax rate
contribution margin ratio

Single Product CVP Analysis

3.

Breakeven Analysis

At breakeven, profits = zero

x*BE
Breakeven sales,

FC
p-v

x*BE

Fixed costs
=
contribution margin per unit

Breakeven sales, S*BE

Fixed costs
=
contribution margin ratio

Multiple Products CVP Analysis

Profits = Revenue Var. Costs Fixed Costs
Z = i pi xi vi xi - FC
i

Multiple Products
CVP Example
Assume sales mix is known
Product

Price

Var. Cost cm per unit Sales mix

$20

$16

$4

$30

$18

$12

Total fixed costs = $24,000

Tax rate = 40%

Multiple Products
CVP Example
1.

2.

3.

Breakeven sales
Sales required for a before-tax profit
target of $120,000

Sales required for an after-tax profit

target of 12% of sales

Multiple Products
CVP Analysis
1.

Breakeven sales
Contribution margin per sales package
=$4 x 3 + $12 x 1
=$24
Breakeven sales packages
=$24,000/$24
= 1,000 sales package
Breakeven sales
A: 1,000 x 3 = 3,000 units
B: 1,000 x 1 = 1,000 units

Multiple Products
CVP Analysis
2.

Sales required for a before-tax profit target of $120,000

Sales packages required

= ($24,000+$120,000)/$24
= 6,000 sales packages
Sales required
A: 6,000 x 3 = 18,000 units
B: 6,000 x 1 = 6,000 units

Multiple Products
CVP Analysis
3.

Sales required for an after-tax profit target of 12% of sales

Revenue per sales package
= $20 x 3 + $30 x 1
= $90
Sales required, S*
S* = [$24,000 + 0.12S* /(1-0.40)] / ($24/$90)
S* = $360,000
X* = 4,000 sales packages
Sales required
A: 4,000 x 3 = 12,000 units
B: 4,000 x 1 = 4,000 units

Margin of Safety

Margin of safety is defined as the excess of

forecasted or budgeted revenue over the
breakeven revenue.
Margin of safety ratio is the ratio of margin
of safety to forecasted or budgeted
revenue.

Degree of Operating Leverage

Operating leverage describes the effect

of cost structure (fixed costs vs variable
costs) on operating income as sales
volume changes.
Degree of operating leverage (DOL) is
defined as the ratio of contribution
margin (CM) to operating income, i.e.,
DOL = CM/(CM-FC)
where FC = total fixed costs

Class Example
Margin of Safety & DOL
Charles Rothman is an importer of silver cuff
bracelets from Mexico. He has a three-month
agreement with the local coffee shop, Dellanos,
to set up a booth to exhibit the jewelery.
Rothman is under no obligation to keep any
unsold items and can return them to the Mexican
silversmith at no personal cost. The average
selling price of the bracelets is $125 and it costs
Rothman $80 to purchase each piece.

Class Example
Margin of Safety & DOL
Dellanos has proposed two payment alternatives for
the use of space.
Option 1: A fixed payment of $435 per month.
Option 2: 12% of the total revenues earned
during the agreement.

(Horngren, Foster, Datar & Gowing. Fifth Canadian Edition, Problem 3-27)

Class Example
Margin of Safety & DOL
Required:
1. Compute margin of safety ratio and
degree of operating leverage at sales
of 50 units and 100 units for each
option.
2. Determine the sales units at which
Rothman will be indifferent between
the two options.

Class Example
Margin of Safety & DOL
Option 1
Breakeven sales
Margin of safety ratio at
sales of 50 units
Margin of safety ratio at
sales of 100 units
Degree of operating
leverage at sales of 50 units
Degree of operating
leverage at sales of 100
units

Option 2

Class Example
Margin of Safety & DOL
Option 1
Breakeven sales
Margin of safety ratio at
sales of 50 units
Margin of safety ratio at
sales of 100 units
Degree of operating
leverage at sales of 50 units
Degree of operating
leverage at sales of 100
units

= $435x3/($125-$80)
= 29 units

Option 2

Class Example
Margin of Safety & DOL
Option 1
Breakeven sales

= $435x3/($125-$80)
= 29 units

Margin of safety ratio at

sales of 50 units

= (50-29)/50
= 42%

Margin of safety ratio at

sales of 100 units

= (100-29)/100
= 71%

Degree of operating
leverage at sales of 50 units
Degree of operating
leverage at sales of 100
units

Option 2

Class Example
Margin of Safety & DOL
Option 1
Breakeven sales

= $435x3/($125-$80)
= 29 units

Margin of safety ratio at

sales of 50 units

= (50-29)/50
= 42%

Margin of safety ratio at

sales of 100 units

= (100-29)/100
= 71%

Degree of operating
leverage at sales of 50 units

= $45x50/($45x50-$435x3)
= 2.38

Degree of operating
leverage at sales of 100
units

= $45x100/($4500-$1305)
= 1.41

Option 2

Class Example
Margin of Safety & DOL
Option 1
Breakeven sales

= $435x3/($125-$80)
= 29 units

Margin of safety ratio at

sales of 50 units

= (50-29)/50
= 42%

Margin of safety ratio at

sales of 100 units

= (100-29)/100
= 71%

Degree of operating
leverage at sales of 50 units

= $45x50/($45x50-$435x3)
= 2.38

Degree of operating
leverage at sales of 100
units

= $45x100/($4500-$1305)
= 1.41

Option 2
= $0/($125-$95)
= 0 units

Class Example
Margin of Safety & DOL
Option 1

Option 2

Breakeven sales

= $435x3/($125-$80)
= 29 units

= $0/($125-$95)
= 0 units

Margin of safety ratio at

sales of 50 units

= (50-29)/50
= 42%

= (50-0)/50
= 100%

Margin of safety ratio at

sales of 100 units

= (100-29)/100
= 71%

= (100-0)/100
= 100%

Degree of operating
leverage at sales of 50 units

= $45x50/($45x50-$435x3) = $30x50/$30x50
= 2.38
= 1.00

Degree of operating
leverage at sales of 100
units

= $45x100/($4500-$1305)
= 1.41

=$30x100/$30x100
= 1.00

Class Example
Margin of Safety & DOL
Sales Units of Indifference
Option 1 income
= Option 2 income
($125-$80)X-$1305 = ($125-$95)X
$15X = $1305
X = 87 units
When sales > 87 units,
Option 1 is preferred to Option 2.

Graphical Representation
1.

Cost-Volume-Profits (CVP) Chart

Costs, $
Total costs
Variable costs

Fixed costs
Units, x

Graphical Representation
1.

Cost-Volume-Profits (CVP) Chart

$
Total revenue

profits
Total costs
losses

xBE

Units, x

Graphical Representation
2.

Profits-Volume Chart

Profits,
Z=px vx - FC

Z=(p v)x - FC
profits
-FC

losses

xBE

Units, x

Assumptions of CVP Analysis

One cost driver, units of output

One revenue driver, units of sales
Costs classified as variable or fixed
Linear cost function

Linear revenue function

Variable cost per unit unchanged

(input price & input quantity unchanged)
Total fixed cost unchanged
(capacity & technology unchanged)
Selling price unchanged

Sales mix unchanged for multiple products

Nonlinear CVP Analysis

$

Total revenue

Total costs

relevant range

Units, x

Other Applications

CVP Analysis under Uncertainty

Breakeven Cashflow
Breakeven Time

Class Example
CVP Analysis under Uncertainty
Price
=
$30
Variable costs
=
$12 per unit
Total fixed costs
=
$36,000
Sales followed a normal distribution with
expected sales of 4,800 units and standard
deviation of 1,200 units.

Class Example
CVP Analysis under Uncertainty
Required:
1.
Determine the expected profit and
probability of achieving expected profit.
2.
Determine the probability of breakeven.
3.
Determine the probability of achieving a
before-tax profit target of $90,000.

Class Example
CVP Analysis under Uncertainty
1.

Determine the expected profit and probability of

achieving expected profit.
Expected profit
= ($30 - $12) x 4,800 - $36,000
= $50,400
Probability of achieving expected profit
= 0.50

Class Example
CVP Analysis under Uncertainty
2.

Determine the probability of breakeven.

Breakeven sales
= $36,000/ ($30-$12)
= 2,000 units
Pr(X > 2,000 units)
= Pr(z > (2,000-4,800)/1,200)
= Pr(z > -2.33)
= 0.9893

Class Example
CVP Analysis under Uncertainty
3.

Determine the probability of achieving a before-tax profit

target of $90,000.
Sales required
= ($36,000+$90,000) / ($30-$12)
= 7,000 units
Pr(X > 7,000 units)
= Pr(z > (7,000-4,800)/1,200)
= Pr(z > 1.83)
= 0.0359