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CHAPTER 7
Cost-Volume-Profit
Analysis

© 2009 Cengage Learning

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Introduction
Cost-volume-profit (CVP) analysis focuses on the
following factors:
1. The prices of products or services
2. The volume of products or services produced
and sold
3. The per-unit variable costs
4. The total fixed costs
5. The mix of products or services produced
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The Contribution Margin Income
Statement

The contribution margin income statement

is structured by behavior rather than by
function.
Sales - All Variable Costs = Contribution Margin
Contribution Margin - All Fixed Costs = Net
Income

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Income Statements
TRADITIONAL CONTRIBUTION MARGIN
Sales $1,000 Sales $1,000
Less: Cost of Goods Sold: Less: Variable Costs:
Variable Costs 350 Manuf. Costs $350
Fixed Costs 150 S, G, & A Costs 50
Total Cost of Goods Sold $ 500 Total Variable Costs $400
Gross Profit $ 500 Contribution Margin $600
Less: S, G, & A Costs: Less: Fixed Costs:
Variable Costs $ 50 Manuf. Costs $150
Fixed Costs 250 S, G, & A Costs 250
Total S, G, & A Costs $ 300 Total Fixed Costs $400
Net Income $ 200 Net Income $200

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The Contribution Margin Income
Statement

Key Concept

The contribution margin income

statement is structured to
emphasize cost behavior as
opposed to cost function.

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Contribution Margin Per Unit

Total Per Unit

Sales (100,000 units) $200,000 $2.00

Less: Variable Costs 80,000 .80
Contribution Margin $120,000 $1.20
Less: Fixed Costs 40,000
Net Income $80,000

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Contribution Margin Per Unit

What if Cheri’s Chips sold one more unit?

Total Per Unit

Sales (100,001 units) $200,002.00 $2.00

Less: Variable Costs 80,000.80 .80
Contribution Margin $120,001.20 $1.20
Less: Fixed Costs 40,000.00
Net Income $80,001.20

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Contribution Margin Per Unit

Key Concept

For every unit change in sales,

contribution margin will increase or
decrease by the contribution margin
per unit multiplied by the increase
or decrease in sales volume.

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Contribution Margin Ratio

Contribution Margin Ratio

Is equal to
Contribution Margin (in $)
Sales (in $)

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Contribution Margin Ratio

Total Percent

Sales (100,000 units) $200,000 100%

Less: Variable Costs 80,000 40
Contribution Margin $120,000 60%
Less: Fixed Costs 40,000
Net Income $80,000 $120,000
$200,000

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Contribution Margin Ratio

Key Concept

The contribution margin per unit and

the contribution margin ratio will
remain constant as long as sales vary
in direct proportion with volume.

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Contribution Margin Ratio

Key Concept
For every dollar change in sales,
contribution margin will increase or
decrease by the contribution margin
ratio multiplied by the increase or
decrease in sales dollars.

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The Contribution Margin and Its 12

Uses
What would happen if sales increase?
Use the CM to determine the increase in net
income. Then consider options to increase
sales.
Lower sales price?
Increase incentives for sales staff?
Improve quality of product?
Increase advertising budget? 12
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Decisions Using CVP

Option 1: Reduce variable costs.

When variable costs are reduced, contribution margin
will increase. Options?
•Find less expensive supplier of raw material
•Reduce the amount of labor used
•Use lower-wage employees
What would be the consequences of each?
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Decisions Using CVP

Lower Variable Costs by $7,200

Current Option 1

Sales $200,000 $200,000

Less: Variable Costs 80,000 72,800
Contribution Margin $120,000 $127,200
Less: Fixed Costs 40,000 40,000
Net Income (Loss) $80,000 $87,200
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Decisions Using CVP

Option 2: Change incentive structure

Raise sales commissions on all sales above the
present level by 10 percent. Sales will increase
by $30,000 or 15,000 bags. Additional sales
commission will be $3,000.

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Decisions Using CVP

Impact of increasing Sales Incentives, Sales =
$230,000

Total Option 2
Sales $200,000 $230,000
Less: Variable Costs 80,000 95,000
Contribution Margin $120,000 $135,000
Less: Fixed Costs 40,000 40,000
Net Income (Loss) $80,000 $95,000

Variable Costs: 230,000*.40% + $3,000

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Decisions Using CVP

Option 3: Increase Advertising

Spending an additional $10,000 on
advertising will increase sales by
$40,000 or 20,000 bags.

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Decisions Using CVP

Impact of increasing advertising: Sales = $140,000

Current Option 3

Sales $200,000 $240,000

Less: Variable Costs 80,000 96,000
Contribution Margin $ 120,000 $ 144,000
Less: Fixed Costs 40,000 50,000
Net Income (Loss) $ 80,000 $ 94,000

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Changes in Price and Volume

If the manager changes the sales price resulting in a

change in sales volume, what will be the impact on
net income?
Raising the sales price may decrease sales volume
but the impact on total sales revenue may be offset
by the increase in sales price.
Decreasing the sales price may increase the sales
volume without increasing total sales revenue.
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Changes in Price and Volume

These business decisions involve individuals in

many areas of an organization, such as marketing,
sales, production management, and even human
resources personnel for hiring decisions. The
implications of a bad decision in this area can affect
the firm’s bottom line.

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Changes in Cost, Price, and 21

Volume

Changes can be made to cost, price, and

volume at the same time.
Changes in one variable almost always
impact one or both of the other variables.

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Break-Even Analysis

Break-Even Point: The level of sales

where contribution margin just covers
fixed costs and consequently net income
is equal to zero.

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Break-Even Analysis

Break-Even =
Fixed Costs
(units) Contribution Margin Per Unit

Break-Even = Fixed Costs

(Sales $) Contribution Margin Ratio

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Break-Even Graph
Revenue
$ Break-Even Point

Profit Area
Total Cost

Break-Even Break-Even Point in Volume

Point
in $

Loss Area
Volume

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Break-Even Calculations with Multiple
Products

The calculation of “average” contribution

margin is really a weighted average.

Fixed Costs
Break-Even (Units) =
Weighted Average Contribution
Margin Per Unit

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Break-Even Calculations Using Activity-
Based Costing

When using activity-based-costing, costs are

classified as unit, batch, product, or facility
level instead of variable or fixed.

Break-Even (units) =
Fixed Costs + Batch-Level Costs + Product-Level Costs
Contribution Margin Per Unit

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Target Profit Analysis
(Before and After Tax)

To determine the sales units required to

achieve a target profit before taxes:

Sales Volume =

Fixed Costs + Target Profit (before taxes)

Contribution Margin Per Unit

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Target Profit Analysis
(Before and After Tax)

Multiple product formula to reach a

target profit:

Sales Volume =
Fixed Costs + Target Profit
Weighted-Average Contribution Margin Per Unit
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Target Profit Analysis
(Before and After Tax)

ABC formula to reach a target profit:

Sales (units) =

Fixed Costs + Batch-Level Costs + Product-Level

Costs + Target Profit
Weighted-Average Contribution Margin Per Unit

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The Impact of Taxes

If
After-Tax Profit = Before-Tax Profit (1-tax rate)
then
Before-Tax Profit = After-Tax Profit / (1-tax rate)
Therefore, to determine after-tax Target Profit

Fixed Costs + After-Tax Profit / (1-Tax Rate)

Sales in units =
Contribution Margin per Unit
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The Impact of Taxes

Key Concept

The payment of income tax is an

important variable in target
profit and other CVP decisions.

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Assumptions of CVP Analysis

1. Selling price is constant throughout the relevant

range.
2. Costs are linear throughout the relevant range.
3. The sales mix used to calculate the weighted
average contribution margin is constant.
4. The amount of inventory is constant.

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Cost Structure and Operating

Leverage

Operating Leverage: The measure of the

proportion of fixed costs in a company’s cost
structure. It is used as an indicator of how
sensitive profit is to changes in sales volume.

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Cost Structure and Operating
Leverage

Contribution Margin
Operating Leverage = Net Income

Operating Leverage X % Increase in Sales = % Increase in

Net Income

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Cost Structure and Operating 35

Leverage

Company B 500 1,000 2,000

Sales $100,000 $200,000 $400,000

Cont. Margin $ 60,000 $120,000 $240,000
Net Income $ 20,000 $ 80,000 $200,000

Operating $60,000 $120,000 $240,000

Leverage $20,000 $80,000 $200,000
3.0 1.5 1.2

10% Increase in Sales 30% 15% 12%

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Cost Structure and Operating 36

Leverage

Key Concept

A company operating near the

break-even point will have a high
level of operating leverage and
income will be very sensitive to
changes in sales volume.
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