4.

Cost-volume-profit (CVP) analysis expands the use of information provided by

breakeven analysis. A critical part of CVP analysis is the point where total revenues
equal total costs (both fixed and variable costs). At this breakeven point (BEP), a
company will experience no income or loss. This BEP can be an initial examination that
precedes more detailed CVP analyses.

Cost-volume-profit analysis employs the same basic assumptions as in breakeven

analysis. The assumptions underlying CVP analysis are:

1. The behavior of both costs and revenues in linear throughout the relevant range of
activity. (This assumption precludes the concept of volume discounts on either
purchased materials or sales.)
2. Costs can be classified accurately as either fixed or variable.
3. Changes in activity are the only factors that affect costs.
4. All units produced are sold (there is no ending finished goods inventory).
5. When a company sells more than one type of product, the sales mix (the ratio of
each product to total sales) will remain constant.

In the following discussion, only one product will be assumed. Finding the breakeven
point is the initial step in CVP, since it is critical to know whether sales at a given level
will at least cover the relevant costs. The breakeven point can be determined with a
mathematical equation, using contribution margin, or from a CVP graph. Begin by
observing the CVP graph in Figure 1, where the number of units produced equals the
number of units sold. This figure illustrates the basic CVP case. Total revenues are zero
when output is zero, but grow linearly with each unit sold. However, total costs have a
positive base even at zero output, because fixed costs will be incurred even if no units are
produced. Such costs may include dedicated equipment or other components of fixed
costs. It is important to remember that fixed costs include costs of every kind, including
fixed sales salaries, fixed office rent, and fixed equipment depreciation of all types.
Variable costs also include all types of variable costs: selling, administrative, and
production. Sometimes, the focus is on production to the point where it is easy to
overlook that all costs must be classified as either fixed or variable, not merely product
costs.

Where the total revenue line intersects the total costs line, breakeven occurs. By drawing
a vertical line from this point to the units of output (X) axis, one can determine the
number of units to break even. A horizontal line drawn from the intersection to the
dollars (Y) axis would reveal the total revenues and total costs at the breakeven point. For
units sold above the breakeven point, the total revenue line continues to climb above the
total cost line and the company enjoys a profit. For units sold below the breakeven point,
the company suffers a loss.

Illustrating the use of a mathematical equation to calculate the BEP requires the
assumption of representative numbers. Assume that a company has total annual fixed cost
of $480,000 and that variable costs of all kinds are found to be $6 per unit. If each unit
sells for $10, then each unit exceeds the specific variable costs that it causes by $4. This
$4 amount is known as the unit contribution margin. This means that each unit sold
contributes $4 to cover the fixed costs. In this intuitive example, 120,000 units must be
produced and sold in order to break even. To express this in a mathematical equation,
consider the following abbreviated income statement:
Unit Sales = Total Variable Costs + Total Fixed Costs + Net Income
Inserting the assumed numbers and letting X equal the number of units to break even:
$10.00X = $6.00X + $480,000 + 0

Note that net income is set at zero, the breakeven point. Solving this algebraically
provides the same intuitive answer as above, and also the shortcut formula for the
contribution margin technique:
Fixed Costs ÷ Unit Contribution Margin = Breakeven Point in Units
$480,000 ÷ $4.00 = 120,000 units

If the breakeven point in sales dollars is desired, use of the contribution margin ratio is
helpful. The contribution margin ratio can be calculated as follows:
Unit Contribution Margin ÷ Unit Sales Price = Contribution Margin Ratio
$4.00 ÷ $10.00 = 40%

To determine the breakeven point in sales dollars, use the following mathematical
equation:
Total Fixed Costs ÷ Contribution Margin Ratio = Breakeven Point in Sales Dollars
$480,000 ÷ 40% = $1,200,000

The margin of safety is the amount by which the actual level of sales exceeds the
breakeven level of sales. This can be expressed in units of output or in dollars. For
example, if sales are expected to be 121,000 units, the margin of safety is 1,000 units
over breakeven, or $4,000 in profits before tax.

A useful extension of knowing breakeven data is the prediction of target income. If a

company with the cost structure described above wishes to earn a target income of
$100,000 before taxes, consider the condensed income statement below. Let X = the
number of units to be sold to produce the desired target income:
Target Net Income = Required Sales Dollars − Variable Costs − Fixed Costs
$100,000 = $10.00X − $6.00X − $480,000

Solving the above equation finds that 145,000 units must be produced and sold in order
for the company to earn a target net income of $100,000 before considering the effect of
income taxes.

A manager must ensure that profitability is within the realm of possibility for the
company, given its level of capacity. If the company has the ability to produce 100 units
in an 8-hour shift, but the breakeven point for the year occurs at 120,000 units, then it
appears impossible for the company to profit from this product. At best, they can produce
109,500 units, working three 8-hour shifts, 365 days per year (3 X 100 X 365). Before
abandoning the product, the manager should investigate several strategies:

1. Examine the pricing of the product. Customers may be willing to pay more than
the price assumed in the CVP analysis. However, this option may not be available
in a highly competitive market.
2. If there are multiple products, then examine the allocation of fixed costs for
reasonableness. If some of the assigned costs would be incurred even in the
absence of this product, it may be reasonable to reconsider the product without
including such costs.
3. Variable material costs may be reduced through contractual volume purchases per
year.
4. Other variable costs (e.g., labor and utilities) may improve by changing the
process. Changing the process may decrease variable costs, but increase fixed
costs. For example, state-of-the-art technology may process units at a lower per-
unit cost, but the fixed cost (typically, depreciation expense) can offset this
advantage. Flexible analyses that explore more than one type of process are
particularly useful in justifying capital budgeting decisions. Spreadsheets have
long been used to facilitate such decision-making.

One of the most essential assumptions of CVP is that if a unit is produced in a given year,
it will be sold in that year. Unsold units distort the analysis. Figure 2 illustrates this
problem, as incremental revenues cease while costs continue. The profit area is bounded,
as units are stored for future sale.

Unsold production is carried on the books as finished goods inventory. From a financial
statement perspective, the costs of production on these units are deferred into the next
year by being reclassified as assets. The risk is that these units will not be salable in the
next year due to obsolescence or deterioration.

While the assumptions employ determinate estimates of costs, historical data can be used
to develop appropriate probability distributions for stochastic analysis. The restaurant
industry, for example, generally considers a 15 percent variation to be "accurate."

APPLICATIONS
While this type of analysis is typical for manufacturing firms, it also is appropriate for
other types of industries. In addition to the restaurant industry, CVP has been used in
decision-making for nuclear versus gas- or coal-fired energy generation. Some of the
more important costs in the analysis are projected discount rates and increasing
governmental regulation. At a more down-to-earth level is the prospective purchase of
high quality compost for use on golf courses in the Carolinas. Greens managers tend to
balk at the necessity of high (fixed) cost equipment necessary for uniform spreadability
and maintenance, even if the (variable) cost of the compost is reasonable. Interestingly,
one of the unacceptably high fixed costs of this compost is the smell, which is not
adaptable to CVP analysis.
Even in the highly regulated banking industry, CVP has been useful in pricing decisions.
The market for banking services is based on two primary categories. First is the price-
sensitive group. In the 1990s leading banks tended to increase fees on small, otherwise
unprofitable accounts. As smaller account holders have departed, operating costs for
these banks have decreased due to fewer accounts; those that remain pay for their keep.
The second category is the maturity-based group. Responses to changes in rates paid for
certificates of deposit are inherently delayed by the maturity date. Important increases in
fixed costs for banks include computer technology and the employment of skilled
analysts to segment the markets for study.

Even entities without a profit goal find CVP useful. Governmental agencies use the
analysis to determine the level of service appropriate for projected revenues. Nonprofit
agencies, increasingly stipulating fees for service, can explore fee-pricing options; in
many cases, the recipients are especially price-sensitive due to income or health concerns.
The agency can use CVP to explore the options for efficient allocation of resources.

Project feasibility studies frequently use CVP as a preliminary analysis. Such major
undertakings as real estate/construction ventures have used this technique to explore
pricing, lender choice, and project scope options.

Cost-volume-profit analysis is a simple but flexible tool for exploring potential profit
based on cost strategies and pricing decisions. While it may not provide detailed analysis,
it can prevent "do-nothing" management paralysis by providing insight on an overview
basis.

Cost-Volume-Profit Analysis
CVP Analysis is a way to quickly answer a number of important questions about the
profitability of a company's products or services. CVP Analysis can be used with either a
product or service. Our examples will usually involve businesses that produce products,
since they are often more complex situations. Service businesses (health care, accounting,
barbers & beauty shops, auto repair, etc.) can also use CVP Analysis.

It involves three elements:

1. Cost - the cost of making the product or providing a service

2. Volume - the number of units of products produced or hours/units of service
delivered
3. Profit - Selling Price of product/service - Cost to make product/provide service =
Operating Profit

The first two items are information available to business managers, about their own
business, products and services. This type of information is not generally available to
those outside the business. They constitute important operating information that can help
managers asses past performance, plan for the future, and monitor current progress. As
for the third item, a business can't stay in business very long without profits.

It is important to know whether the company is profitable as a whole. It is also important

to know if a particular product is profitable. A business that sells 100 or more different
products may lose sight of a single product. If that product becomes unprofitable (selling
for less than the cost to produce & sell), the company will lose money on each and every
sale of that product. The company might raise the selling price, cut production costs or
discontinue the product entirely. Building a business with 100 products we know are
profitable is good management. CVP & variable costing provide the tools to make this
happen in a real business.

A successful business can be built around a single profitable product. It can also be built
around hundreds or thousands of profitable products. Many businesses start small and
grow over time, adding products as they gain experience and are able to identify and/or
develop new markets and products. No matter the size of the business or the number of
products, the same rules apply. Each product must "carry its own weight" for the business
to be profitable.

Using CVP Analysis we can analyze a single product, a group of products, or evaluate
the entire business as a whole. The ability to work across the entire product line in this
way gives us a powerful tool to analyze financial information. It provides us with day-to-
day techniques that are easy to understand and easy to use. The concepts parallel the real
world, so they are easy to visualize and use. The math is very simple - no complex
formulae or techniques. Just simple formulae that can be easily modified to analyze a
large variety of situations.

Quiz Yourself

CVP Analysis is important because:

a. the teacher says so.
b. it sounds cool to say "see vee pee".
c. it is a good way to analyze the profitability of a company's products or services.
d. I haven't a clue.

Answer

CVP Analysis is important because:

a. the teacher says so.
b. it sounds cool to say "see vee pee".
c. it is a good way to analyze the profitability of a company's products or services.
d. I haven't a clue.
CVP Relationships

Cost - product cost, consisting of materials, labor, overhead, etc.

Volume - number of units of product sold in a given period of time
Profit - Selling Price minus Cost, per unit or in total

The greater the volume, the greater the TOTAL profit.

Approaches to product costs

Full Costing is used in financial accounting. The full cost of a product includes
materials, labor and manufacturing overhead. Not included: Selling and administrative
costs.

Variable Costing is used in managerial accounting. Costs are classified as either

Variable or Fixed, depending on their Cost Behavior.

Cost Behavior

Costs are classified according to how they behave, in relation to units of production.

CAUTION: Cost behavior can be viewed in terms of total costs or unit costs. Both
approaches will be used, but they are not interchangeable.

Fixed Costs

Total Fixed Costs - stay essentially the same month to month, regardless of the number
of units produced.
Unit Fixed Costs - goes down as production goes up

Variable Costs

Total Variable Costs - go up and down in direct proportion to units produced.

Unit Variable Costs - stay the same regardless of how many units are produced.

Accounting information is captured once by the accounting system. In Accounting I you

learned how to analyze transactions, record journal entries, post to the ledger accounts
and prepare financial statements for use by those outside the company. That is one way to
organize accounting information, but it is not the only way. That same information can be
organized in many different ways. In this section we are going to simplify the process
greatly. Our topic is Cost-Volume-Profit, so we will focus on income statement accounts,
Revenues and Expenses. For now we can ignore balance sheet accounts.

Managers focus on income statement accounts because these are the ones affected by
day-to-day operating activities. Companies produce/purchase and sell products or
services. Companies may uses hundreds of income statement accounts to track all their
different types of revenues and expenses. We are going to simplify the income statement
by dividing all expenses into one of two categories: Variable and Fixed. To master this
material you need to master these two concepts.

VARIABLE COSTING - in general

CVP Analysis uses Variable Costing concepts. In this context we will divide ALL costs
into one of two categories: Variable or Fixed. We refer to this as "cost behavior." In CVP
Analysis cost behavior will be discussed on BOTH a total cost and per unit basis. The
facts will remain the same, but the behavior will appear different, depending on the
context. Read carefully, especially on exams and in problems, so you understand the
context of the question/problem: total cost or per unit. Since CVP Analysis can answer
questions about both, we will switch back and forth frequently in our discussion. Tighten
you "thinking bolts" and read carefully in this section.

In CVP Analysis we assume that the number of units produced equals the number of
units sold. In other words, we factor out changes in inventory during a production period.
In the "real world" managers often include inventory changes & income taxes in CVP
Analysis. In this course we will ignore both inventory changes and income taxes. Here,
you should gain a basic working knowledge of CVP Analysis fundamentals.

VARIABLE COSTS (VC)

Total Variable Costs increase in direct proportion to production/sales.

Unit Variable Costs stay the same as production fluctuates within the relevant range.

EXAMPLE: Mike's Bikes builds the X-Racer from its inventory of parts. Each bicycle is
made up of the following parts:

• frame (1)
• seat (1)
• handlebars (1)
• wheels (2)
• tires (2)
• gears & shifting system (1)
• brakes & braking system (1)

Parts prices vary over time. Currently the cost to produce one bicycle is $70.

UNITS of Product : X-Racer Cost Per Unit Total Costs

1 bicycle @ $70

1 bicycle = $70
= $70
2 bicycles @ $70

1 bicycle = $70
= $140
3 bicycles @ $70

1 bicycle = $70
= $210
Per Unit costs stay the same; total costs increase in direct proportion to the number of
units produced or sold (sales or production volume). The Relevant Range is the number
of units that can be produced or sold under normal circumstances. That might vary due to
seasonal demand or factory capacity. To go beyond the relevant range would generally
require the additional of more equipment, buildings, personnel, etc. and that would cause
a change in all costs. We presume that we are working within the relevant range when
doing CVP Analysis. This makes the task much easier. It also helps us understand when
we will need to address the need to expand our business.

Variable Costs include any total cost that varies in direct proportion to volume.
These commonly include:

• component parts, packaging, etc.

• production labor
• sales commissions (percentage or per unit basis)
• other costs allocated on a per unit basis

FIXED COSTS (FC)

Total Fixed Costs (FC) do not change as production/sales increases.

Unit Fixed Costs decrease as production increases within the relevant range.

Ask yourself this question: Would a cost be zero if production was zero? If the answer is
NO, you are looking at a fixed cost. A common example would be rent on a building. The
company must pay rent on the building even if it sells no products in a given month!
Some other common costs that follow this pattern are:

• managers & executives salaries

• insurance
• advertising
• real estate & property taxes
• security service
• cleaning & maintenance costs
• depreciation expense on buildings, vehicles & equipment

EXAMPLE: Mike's Bikes spends $5,000 per month in fixed costs.

If they make X bicycles per month.... their fixed costs PER UNIT will be......
1,000 bicycles $5,000 / 1,000 bicycles = $5.00 per bicycle
2,000 bicycles $5,000 / 2,000 bicycles = $2.50 per bicycle
3,000 bicycles $5,000 / 3,000 bicycles = $1.67 per bicycle
4,000 bicycles ????????? Quick Quiz try these on your own
5,000 bicycles ?????????

Answer:
$5,000 / 4,000 bicycles = $1.25 per bicycle
$5,000 / 5,000 bicycles = $1.00 per bicycle

Quick Quiz

Do Total Fixed Costs change as production goes up?

Answer:

NO.

Total Fixed Costs stay the same as production goes up.

Unit Fixed Costs decrease as productions goes up.

Since Fixed Cost per Unit goes down as sales/production go up, it is always a good idea
to sell/produce more units. In the real world, companies try to produce approximately the
same number of units they expect to sell in a given period of time. If you think about the
computer industry you will see how important this can be. If a computer company
manufactures too many units it may have a stock of merchandise that is hard to sell as
new computer chips are introduced to the market. It may have to sell its products at a
discount or even at a loss to liquidate its inventory. Chapter 8 discusses "Just In Time"
(JIT) inventory management, which is used to help reduce inventory costs, by having
parts delivered "just in time" to go into production. JIT inventory systems are commonly
used in automobile assembly plants. Using JIT reduces a company's risk of carrying a
stock of parts that may quickly become obsolete.

MIXED COSTS

Mixed costs change somewhat in relation to production, but not proportionately like
Variable Costs do. Mixed costs generally have a fixed portion and a variable portion. We
deal with these costs by separating them into these two parts - so we are back to only 2
types of cost behavior.

A common example of a mixed cost would be a rental car. You might rent a car for a
weekend for $20, for up to a total of 200 miles. You will be charged $ .10 for each
additional mile you drive. The flat rate of $20 represents the fixed component; the $ .10
per mile represents the variable component. If you drive 300 miles you will pay:
 Fixed component $20.00
Variable component $10.00 (100 extra miles @ $ .10)
Total cost $30.00

We have a couple of simple ways to separate costs into their fixed and variable
components. One way is called the High-Low Method. It looks at the highest & lowest
costs over a period of several months to come up with a simple formula that can be used
to calculate the variable & fixed costs. Separating mixed costs into their parts is an in-
exact practice. At best it is an estimate, or approximation, that is only as accurate as the
method we use. This is not usually a significant issue, since all costs are eventually
included in our equations. However, if mixed costs constitute a percentage of total costs,
it is necessary to be as accurate as possible. More sophisticated methods should be used
when a higher level of accuracy is needed.

Contribution Margin

The Contribution Margin (CM) is one of the most essential parts of variable costing and
managerial accounting.

CM = Selling Price - Variable Costs

It can be calculated as either unit CM or total CM.

CM is the profit available to cover fixed costs and provide net income to the owners.

Break Even analysis

One of the first uses of variable costing is calculating the break even point. This is the
point at which sales exactly equals total costs. It can be expressed as either units or sales
dollars.

Break Even Units (BE units)- the number of units needed to cover fixed costs for a given
period of time.

----------------------------------------------------

BE units example:

XYZ Co. has monthly fixed costs of $2,000. They sell a single product for $30 each.
Variable costs are $10 per unit. They sell about 200 units per month. Calculate the break
even point in units.

1) Calculate CM

Selling price $ 30
Variable costs 10
Contribution margin (CM) $ 20

2) Calculate BE units

Total Fixed Costs 2000 100 units to break even

BE Units = = =
Unit CM 20

proof:

Contribution margin 100 units @ $20 $ 2000

less Total Fixed Costs 2000
Profit (loss) $0

When sales are below the Break Even point a company is operating at a loss; Above the
BE point they will be operating at a profit. The company is selling 200 units per month,
well above the break even point, so they are operating at a profit.

How much profit will they make by selling 200 units per month?

Contribution margin 200 units @ $20 $ 4000

less Total Fixed Costs 2000
Profit at 200 units per month $ 2000

----------------------------------------------------
Example 2:

XYZ is facing fierce competition from a new company, and management decides to
lower the selling price of their product to $20 per unit. They also decide to take out
advertising at a cost of $400 per month. Recalculate their Break Even point given the new
information:

1) Calculate CM

Selling price $ 20
Variable costs 10
Contribution margin $ 10

2) Calculate BE units
The $400 advertising costs will increase total fixed costs; add it to the numerator (top
number).

Total Fixed Costs 2400

BE Units = = = 240 units at break even
Unit CM 10

This will be a problem for the company. Their new break even point is higher than their
normal monthly sales. They will be operating at a loss under these conditions, and must
re-evaluate the decision.

proof:

Contribution margin 200 units @ $10 $ 2000

less Total Fixed Costs 2400
Profit (loss) ($ 600)

----------------------------------------------------

Example 3
:
We can work the formula in reverse. Assume they include the advertising costs of $400
per month, and sell 200 units. What selling price will put them at the break even point?
 $2400
CM Unit at BE = = $12 CM
200

They must reverse the calculation, and add variable costs to CM to arrive at the new
selling price.

Contribution margin $ 12
Variable costs + 10
Selling price $ 22

Proof:

Selling price $ 22
Variable costs 10
Contribution margin $ 12

Total Fixed Costs 2400

BE Units = = = 200 units at break even
Unit CM 12

proof:

Contribution margin 200 units @ $12 $ 2400

less Total Fixed Costs 2400
Profit (loss) $ 0

CM Ratio and BE sales volume

The CM can also be viewed as a percentage or ratio. To calculate the CM ratio, divide
CM by the Selling Price (SP).

ABC Co. has monthly fixed costs of $2,400. They sell a single product for $40 each.
Variable costs are $24 per unit. They sell about 250 units per month. Calculate their
break even point in sales dollars (also called sales volume).

Selling price $ 40
Variable costs 24
Contribution margin $ 16

Their CM Ratio is CM/SP = 16/40 = .40 or 40%

(In accounting we usually carry calculations out to 4 decimal places).

Break Even Sales Volume

Total Fixed Costs / CM Ratio = 2400/.40 = $6000 in sales per month

proof:

$6000 / $40 SP per unit = 150 units to break even, or:

2400
BE Units = = 150 units at break even
16

When do we use CM Ratio and BE sales volume?

We can use these calculations anytime. They are especially useful when the company
sells a large number of different products - in other words a large sales mix. Take for
example a convenience store. They might sell 200 different items, or more. Each item
carries its own selling price, and contribution margin per unit.

Calculating all those contribution margins would be a huge job. And with a sales mix, the
company would have to carefully track each and every product. It is much easier to
consider the merchandise as a large group, and use the CM Ratio.

QuikMart operates a convenience store, and their CM Ratio is approximately 42%. Their
monthly overhead (fixed costs) is $2604. What sales volume is needed to break even?

BE volume = TFC / CM Ratio = $2604 / .42 = $6200 per month in sales volume

It is not necessary for the owner to know exactly how many Snickers bars, Milky Way,
cans of Coke etc. will be sold each month. That will depend on the what the customers
want to buy. The owner will stock a variety of products. By using CM Ratio we don't
need to know each item individually.
Of course, in the real world not all products will earn the same CM Ratio. Some products
face stiff competition, and the company will charge accordingly. For instance, they will
sell milk at a price similar to grocery stores, earning a rather small CM. But the neat
trinkets that adorn the front counter will be sold for twice, three, four times or more their
cost, greatly improving the company's overall profit margin. A few high profit items can
make up for the "loss leaders" in a company's product mix.

[Loss leaders are products sold at a low price, sometimes at a loss, to attract customers,
and get them to shop in your store. Free items, 2-fer sales, 1 cent sales, etc. are all
examples of the loss leader strategy used by grocery stores to get your business. They
hope you will buy some of the high profit items while you are shopping in their store.
Sometimes they will require a minimum purchase, or limit the number of loss leader
items a customer can buy.]

CVP Graphs

CVP relationships and the break even formula can all be illustrated with a simple graph.
CVP graphs are a great way to convey information. They are especially useful in
presenting alternatives to decision makers, many of whom may more easily grasp the
concepts with a visual presentation, rather than page full of numbers.