Chapter 3

BREAK-EVEN POINT AND

COST-VOLUME-PROFIT
ANALYSIS
Dr. Le Hoang Oanh
QUESTIONS ADDRESSED BY
COST-VOLUME-PROFIT ANALYSIS

CVP analysis is used to answer questions

such as:
§ How much must I sell to earn my desired income?
§ How will income be affected
if I reduce selling prices to
increase sales volume?
§ What will happen to
profitability if I expand
capacity?
LEARNING OBJECTIVES

Understanding basic concepts in cost-volume-profit

relationships:
Relationships between volume and profit (contribution margin)
Relationships between sales and profit (contribution margin
ratio)
Relationships between sales growth rate and profit growth
rate (operating leverage)
Applying C-V-P relationships to decision making
(Show the effects on contribution margin of changes in
variable costs, fixed costs, selling price and volume)
LEARNING OBJECTIVES

Compute the break-even point

Use the C-V-P formulas to determine the activity level
needed to achieve a desired target net profit figure
access safety in business (margin of safety, margin
of safety percentage)
Effects of shifts in the sales mix on contribution margin
and the break-even point
Assumptions of CVP analysis
CONTENTS

Basic concepts in CVP relationships

Applying CVP relationships to decision making
Break-even analysis
Sales mix analysis
Assumptions of CVP analysis
BASIC CONCEPTS IN CVP
RELATIONSHIPS
BASIC CONCEPTS IN CVP RELATIONSHIPS

Contribution margin
Contribution margin ratio
Cost structure
Operating leverage
CONTRIBUTION MARGIN

Contribution margin = Sales – Variable costs

CM is used first to cover fixed costs. Any remaining CM

contributes to net operating income.

Example 1:

Pringle Company manufactures and sells a single product.

Prepare the contribution income statement under the
following information in December 20x8:

- Units sold: 500 - unit selling price: 40

- variable costs per unit: 24 - Total fixed costs: 4,000

CONTRIBUTION MARGIN
Pringle company
Contribution Income statement
For the month of December 2008

Total Per unit

Sales
(-) Variable costs
Contribution margin
(-) Fixed costs
Contribution margin per unit =
Net income incremental (decremental) operating
income when selling one more (less) 1
unit of product (fixed costs
unchanged)
 Incremental (decremental) CM = units sold
CONTRIBUTION MARGIN more (less) * CM per unit (unit selling price,
variable costs per unit unchanged)

Number of units sold

0 1 2 250 251 400 500

Sales 80 10,000 10,040 16,000 20,000

VC 48 6,000 6,024 9,600 12,000

CM 32 4,000 4,016 6,400 8,000

FC 4,000 4,000 4,000 4,000 4,000

Op.Income (3,968) 0 16 2,400 4,000

Incremental 16 16 2,384 1,600

Op.income

Incremental (decremental) operating

income = incremental (decremental)
CM (FC unchanged)
CONTRIBUTION MARGIN
Profit = CM of units above the break-even point
Loss = CM of units below the break-even point (units which needs to be
sold to break-even point

Number of units sold

0 1 2 250 251 400 500
Sales 0 40 80 10,000 10,040 16,000 20,000
VC 0 24 48 6,000 6,024 9,600 12,000
CM 0 16 32 4,000 4,016 6.400 8,000
FC 4,000 4,000 4,000 4,000 4,000 4,000
Op.Income (3,984) (3,968) 0 16 2,400 4,000

Loss = units below the break- Profit = units above the break-
even point * CM per unit even point * CM per unit

CM reflects relationships between volume and profit à managers can quickly

determine operating income
CONTRIBUTION MARGIN

Continue Example 1:
Pringle estimate number of units sold increases by
30% in Jan 20x9, estimate operating income if unit
selling price, variable exp per unit and fixed costs are
unchanged.
CONTRIBUTION MARGIN
CONTRIBUTION MARGIN

Disadvantages:

In multiple products company, managers can easily

confuse “Increasing sales of products with high
contribution margin per unit, net operating income will
higher” à wrongly decision making.
CONTRIBUTION MARGIN RATIO

Total CM
CM Ratio =
Total sales
CM per unit
CM Ratio =
Unit selling price

Unit selling price, VC per unit unchanged

Incremental Incremental x CM ratio

=
(decremental) CM (decremental) sales

FC unchanged

Incremental = Incremental
(decremental) operating income (decremental) CM
CONTRIBUTION MARGIN RATIO

CM ratio reflect relationships between sales and profit

managers can quickly determine operating income
CONTRIBUTION MARGIN RATIO

Continue Ex 1
Estimated sales in 1/20x9 is 25,000. Estimated
operating income?
CONTRIBUTION MARGIN RATIO
CONTRIBUTION MARGIN RATIO

Useful analyzing instrument in decision making à if

increasing in the same sales, products with high CM
ratio can obtain a higher increase in operating income.
COST STRUCTURE
Cost structure refers to the relative proportion of fixed and
variable costs in an organization
Example 2: Company A, B & C have contribution income
statements in 08/20x8

Company A Company B Company C

Total % Total % Total %

Sales 100,000 100% 100,000 100% 100,000 100
%
VC 15,000 15% 80,000 80% 95,000 95%
CM 85,000 85% 20,000 20% 5,000 5%
FC 80,000 15,000 0
Operating 5,000 5,000 5,000
Income
COST STRUCTURE

Supposing sales increases by 50,000 in each of these

companies, other information unchanged. Compute their
income.
COST STRUCTURE

Solution
Company A
COST STRUCTURE

Solution
Company A

Com A’s rapid

growth

Company B % fixed costs (A) > (B) > (C)

Incremental OI = 50,000 * 20% = 10,000 Increasing in the same sales

OI new = 5,000 + 10,000 = 15,000 Percent increase in profit of
(A) > (B) > (C)
Company C
Incremental OI = 50,000 * 5% = 2,500
OI new = 5,000 + 2,500 = 7,500
COST STRUCTURE

Supposing sales decreases by 20,000 in each of these

companies, other information unchanged. Compute their
income.
COST STRUCTURE

Solution
Company A
COST STRUCTURE

Solution
Company A % fixed exp of
(A) > (B) > (C)
Decreasing in the
Company B same sales
Decremental OI = 20,000 * 20% = 4,000
Percent decrease in
OI new = 5,000 – 4,000 = 1,000 profit of (A) > (B) >
Company C (C)
Decremental OI = 20,000 * 5% = 1,000
Company A’s losses
OI new = 5,000 – 1,000 = 4,000 is biggest
COST STRUCTURE
There are advantages and disadvantages to high fixed
cost (or low variable cost) and low fixed cost (or high
variable cost) structures.

An advantage of a high fixed

cost structure is that income A disadvantage of a high fixed
will be higher in good years cost structure is that income
compared to companies will be lower in bad years
with lower proportion of compared to companies
fixed costs. with lower proportion of
fixed costs.

Companies with low fixed cost structures enjoy greater

stability in income across good and bad years
OPERATING LEVERAGE

A measure of how sensitive net operating income is

to percentage changes in sales.

Percentage changes in
Degree of net operating income
Operating = >1
Percentage changes in
leverage
sales

How a percentage change in sales volume will affect profits.

OPERATING LEVERAGE
The degree of operating leverage at a given level of sales is
computed by following formula

Degree of Operating Contribution margin

=
leverage Net operating income
Operating leverage is a measure of the extent to which fixed costs
are being used in an organization and its effects on change in sales
due to change in net operating income

High fixed cost structure à high CM ratio à income will be very

sensitive to changes in sales (high Operating Leverage)

Low fixed cost structure à low CM ratio à income will be less

sensitive to percentage changes in sales (low Op.Leverage)
OPERATING LEVERAGE

Example 3:

Continue Exp 2, with requirements as follows:

1. What is the degree of operating leverage in each

company? What does it mean?

2. Compute again operating income of each company in 2

situations: sales increases by 50,000 and decreases by
20,000.
OPERATING LEVERAGE

1. OL (A) =

OL (B) =

OL (C) =

Meaning:

Degree of OL (A) = …..: with unit selling price, unit

variable cost and fixed costs are unchanged, sales
increase (decrease) by 1%, net income increases
(decrease) by ……… % in company A
OPERATING LEVERAGE
2. Sales increases by 50,000
OPERATING LEVERAGE
2. Sales increases by 50,000
Company A

Company B
Incremental OI = 4* 50% = 200% or 5,000 * 200% = 10,000
OI new = 5,000 + 10,000 = 15,000
Company C
Incremental OI = 1 * 50% = 50% or 5,000 * 50% = 2,500
OI new = 5,000 + 2,500 = 7,500
 OPERATING LEVERAGE

2. Sales decreases by 20,000

 OPERATING LEVERAGE

2. Sales decreases by 20,000

Company A

Company B
Decremental OI = 4* 20% = 80% or 5,000* 80% = 4,000
OI new = 5,000 – 4,000 = 1,000
Company C
Decremental OI = 1 * 20% = 20% or 5,000 * 20% = 1,000
OI new = 5,000 – 1,000 = 4,000
Same results to Exp 2 à quickly estimate what impact various
percentage changes in sales will have on profits
Quickly estimate percentage changes in sales to obtain target profits
OPERATING LEVERAGE

The degree of operating leverage is different at

different level of sales

Units sold = 0 à OL = 0

0 < Units sold < BEP à OL < 0 (OL reflects percent

decrease in loss with 1% increase in sales).

Units sold > Break-even point à OL > 0 and will be

decreased to 1 the father the company moves from its
BEP.
OPERATING LEVERAGE

Example 4:

Company D has information as follows

- Unit selling price: 30

- Unit VC: 20

- Total FC: 20,000

Requirement: Compute degree of operating leverage at

given number of units sold: 0 unit 1,000 units, 1,500 units,
2,000 units, 2,500 units, 3,000 units and 6,000 units.
OPERATING LEVERAGE
Solution
0 1,000 1,500 2,000 2,500 3,000 6,000
Sales 45,000 60,000 75,000 90,000 180,000
VC 30,000 40,000 50,000 60,000 120,000
CM 15,000 20,000 25,000 30,000 60,000
FC 20,000 20,000 20,000 20,000 20,000
OI -5,000 0 5,000 10,000 40,000
OL -3 ∞ 5 3 1.5
APPLYING CVP RELATIONSHIPS
TO DECISION MAKING
APPLYING CVP RELATIONSHIPS TO DECISION MAKING
Keep current business plan? Or: Economically,
choosing a plan
§ Change in fixed costs and sales
which has a change
volume? in CM is bigger than
§ Change in variable costs and sales a change in fixed
volume? costs
§ Change in fixed costs, sales price and
Analyzing method:
sales volume? Step 1: Compute
§ Change in fixed costs, variable costs change in CM
and sales volume? Step 2: Compute
change in fixed costs
§ Change in fixed costs, variable costs,
Step 3: Compare
sales price and sales volume? change in CM and
§ Change in regular sales price change in Fixed costs
APPLYING CVP RELATIONSHIPS TO DECISION MAKING

Example 5:
Enfa Company
Contribution income statement
For the month of may, 20x8

Total Per unit Percent

Sales 150,000 150 100%
(-) Variable costs 60,000 60 40%
Contribution margin 90,000 90 60%
(-) Fixed costs 50,000
Net operating income 40,000
CHANGE IN FIXED COSTS AND SALES VOLUME

Manager is contemplating a $20,000 increase in the

monthly advertising budget which would increase monthly
units sold by 30%. Would you recommend that the
advertising campaign be undertaken?
CHANGE IN FIXED COSTS AND SALES VOLUME

Solution:
Based on contribution margin per unit
CHANGE IN FIXED COSTS AND SALES VOLUME

Based on CM ratio
CHANGE IN FIXED COSTS AND SALES VOLUME

• Based on operating leverage

CHANGE IN VARIABLE COSTS AND SALES VOLUME

Management is contemplating the use of lower-quality

raw materials, which would save $10/unit. However, the
sales manager predicts that using lower-quality raw
materials lead to lower-quality products which would
decrease number of unitts sold by 20%. Would you
recommend the use of the lower-quality raw materials?
CHANGE IN VARIABLE COSTS AND SALES VOLUME

Solution:
 CHANGE IN VAR. COSTS, SALES PRICE AND SALES VOLUME

To increase sales, the sales manager would like to cut

the selling price by $10/unit and increase the advertising
budget from $5,000 to $10,000 per month. The sales
manager argues that these two steps are taken, unit sales
will increase by 30%. Should the changes be made?
CHANGE IN VAR. COSTS, SALES PRICE AND SALES VOLUME
CHANGE IN FIXED COSTS, VAR. COSTS, & SALES
VOLUME

The sales manager would like to place the sales staff

on a commission basis of $20/unit sold, rather than on
flat salaries that now total $20,000 per month. The sales
manager is confident that the change will increase
monthly sales to 1,200 units. Should the change be
made?
CHANGE IN FIXED COSTS, VAR. COSTS, & SALES
VOLUME
CHANGE IN FIXED COSTS, VAR. COSTS,
SALES PRICE & SALES VOLUME

The sales manager would like to place the sales staff

on a commission basis of $20/unit sold, rather than on
flat salaries that now total $20,000 per month. He also
would like to cut the selling price by $8/unit. The sales
manager is confident that the change will increase
monthly unit sales by 40%. Should the change be made?
CHANGE IN FIXED COSTS, VAR. COSTS,
SALES PRICE & SALES VOLUME
CHANGE IN REGULAR SALES PRICE
Suppose Enfa sold 1,000 units (regular unit sales) and
still has excessive capacity. Enfa has an opportunity to
sell 300 units to a wholesaler if the price can be reduced
by 20%. Enfa has to delivery to their door. Shipping costs
is estimated to be $4,800. What price would be quoted
to the wholesaler if Enfa wants to increase its monthly
profits by $5,400? Should this deal be made?
CHANGE IN REGULAR SALES PRICE
BREAK-EVEN ANALYSIS
BREAK-EVEN ANALYSIS

Break-even point computations

CVP Relationship in Graphic form
Target net profit analysis
The margin of safety
BREAK-EVEN POINT COMPUTATIONS

At break-even point:

Total sales = Total costs

(Total Contribution margin = Total fixed costs)

pxBE = axBE + b
with p: sales price
xBE: Break-even point in units sold
a: unit variable cost
b: total fixed costs
 BREAK-EVEN POINT COMPUTATIONS

Formula for the break-even point in unit sales and sales dollars.

In single product company xBE = b/(p – a)

Break-even point Total fixed costs

in unit sales (a1)
= Unit sale price – unit var.cost

Total fixed costs

or = (a2)
Unit contribution margin

Break-even point in sales dollars

or = (a3)
Unit Sales price
BREAK-EVEN POINT COMPUTATIONS

pxBE = b/[(p – a)/p]

Break-even point Total fixed costs (b1)

=
in sales dollars Contribution margin ratio

(b2)
Total fixed costs
or =
1 – variable costs/sales
(b3)
or = Break-even point in unit
sales * unit sales price
BREAK-EVEN POINT COMPUTATIONS

In multiple product company:

Step 1: Compute company’s break-even point in

sales dollars: using formula b1 or b2

Step 2: Compute break-even point in sales dollars of

each product = company’s break-even point
in sales dollars * % sales of each product.

Step 3: Compute break-even point in unit sales of

each product: using formula a3
BREAK-EVEN POINT COMPUTATIONS
BREAK EVEN POINT GRAPH
Sales and Exp
y = px
y

Break-even Profit y = ax + b
point area

Break-even point
in sales dollars
y = ax

Loss y=b
area

Break-even point
in unit sales x

Volume 63
BREAK-EVEN POINT COMPUTATIONS

y NET OPERATING INCOME’S GRAPH

Profit or
loss

y = (p – a) x – b
Break-even
point
Profit
area x
Loss Volume
area

-b
BREAK-EVEN POINT COMPUTATIONS

Example 6:
Company F which produces and sells 2 products, including A and
B has income statement as follows:

Product A Product B Company

Total Per unit Total Per unit Total
Sales 40,000 20 60,000 15 100,000
VC 20,000 10 12,000 3 32,000
CM 20,000 10 48,000 12 68,000
FC 40,800
Net O.I 27,200

Compute break-even point in unit sales and in sales

dollars of each product.
BREAK-EVEN POINT COMPUTATIONS

Company’s break-even
=
point in sales dollars
=

Product A’s break-even =

point in sales dollars
=

Product B’s break- =

even point in sales
dollars

=
TARGET NET PROFIT ANALYSIS

Contribution margin = Fixed costs + Profit

(Sales = Variable costs + Fixed costs + Profit)

(p – a)x = b + P

with p: unit sales price

x: unit sales to attain the target profit
a: variable costs per unit
b: total fixed costs
P: target profit
TARGET NET PROFIT ANALYSIS

In single product company

x = (b + P)/(p – a)

Unit sales Fixed costs + target net profit

= (c1)
to attain Unit selling price – Unit variable
the net costs
target profit

or Fixed costs + target net profit (c2)

=
Contribution margin per unit

Sales to attain the net target profit (c3)

or =
Unit sales price
TARGET NET PROFIT ANALYSIS
px =(b + P)/[(p – a)/p]

Sales to attain Fixed costs + Target net profit

the target
= (d1)
Contribution margin ratio
profit

Fixed costs + Target net profit (d2)

or =
1 – variable costs/sales

or = Unit sales to attain the target (d3)

profit * unit sales price
TARGET NET PROFIT ANALYSIS

In multi product company

Step 1: Compute Company’s Sales to attain target

net profit: Using formula d1 or d2

Step 2: Compute Sales to attain target net profit of

each product = Company’s Sales to attain
target net profit * % sales of each product.

Step 3: Compute unit sales to attain target net profit

of each product: using formula c3
TARGET NET PROFIT ANALYSIS
Example 6:
Binh Minh Company a) Compute
Contribution income statement sales in unit
For the month of Jan, 2008 and sales in
dollars to attain
Total Per unit %
net profit of
Sales 500,000 1,000 100%
$150,000 in
(-) Variable costs 300,000 600 60%
Freb, 2008
Contribution margin 200,000 400 40%
(-) Fixed costs 80,000
Net operating income 120,000

b) Suppose in Feb 2008, Applying new strategy, sales officer

will get a commission of 100 per unit above break-even point
rework question a.
BREAK-EVEN POINT COMPUTATIONS
MARGIN OF SAFETY

The margin of safety is the excess of budgeted (or

actual) sales over the break-even sales

Margin of safety = Total sales – Break-even sales

Margin of safety Margin of safety

= x 100%
percentage Total sales
MARGIN OF SAFETY
Company X Company Y

Total % Total %

Sales 500,000 100% 500,000 100%

Variable costs 350,000 70% 200,000 40%

CM 150,000 30% 60%

300
Fixed costs 90,000 240,000

Profit 60,000 60000

Break-even point FC/CM ratio

300 400 240000/ 60%
= 90000 / 30%
in sales dollars
Margin of safety 200
100

% Margin of 40% 200 / 500 20% 100 / 500

safety
MARGIN OF SAFETY
margin of safety means the Company X Company Y
max revenue can be reduced
to still earn a positive profit Total % Total %
Sales 500,000 100% 500,000 100% same
revenue,
Variable costs 350,000 70% 200,000 40% same
profit
CM 150,000 30% 300,000 60% -> same
Fixed costs 90,000 240,000 total cost

Profit 60,000 60,000

BE point in sales dollars 300,000 400,000
Margin of safety 200,000 100,000
Margin of safety percentage 40% 20%
Company Y has ………
a higher fixed costs structure à …...……
higher CM ratio ->
lower
……………. margin of safety
In Company ..……, Y if Sales is reduced, profit is significantly……………
decreased
Specifically, if its sales is reduced by $….……..,100 it gets break-even point ; while
Company ……., X to have zero in operating income, sales is decreased by
200
$…………. %FC/ total cost = 900/440 < 240/440
X Y
SALES MIX ANALYSIS
SALES MIX ANALYSIS

Concept of sales mix

Average Contribution margin ratio

Choosing an appropriate sales mix

Rev = 40% Rev. = 60%

Product A Product B

3rd case: Rev. A = 50% Re. B = 50%

average CM ratio = % CM ratio A * % Rev. A + % CM ratio b * % Rev. B

total CM comp. = Average CM ratio * total rev. comp.

Profit decrease
SALES MIX ANALYSIS
Sales mix is the relative proportion in which a
company’s products are sold

Exp 6: Company F which produces and sells 2 products, including A

and B has income statement as follows:
Product A Product B Compan
y
Total % Total % Total
Sales 60,000 100% 40,000 100% 100,000
Var. costs 30,000 50% 8,000 20% 38,000
CM 30,000 50% 32,000 80% 62,000
Fixed costs 40,800
Net O.Income 21,200
Sales mix: + Product A: ……….. + Product B: …………..
 AVERAGE CONTRIBUTION MARGIN RATIO

n
∑ CM of product i
Average CM ratio = i=1
n

= CM ratio company ∑ Sales of product i

i=1

Total company’s CM
= Total company’s
sales
n
or = ∑ (CM ratio of product i x % sales of product i)
2nd >< 1st i=1

Average CM ratio = total CM comp / total sales rev. comp

profit FC unchanged -> total profit comp.

BER BER = total FC comp. / average CM ratio

Margin of safety = sales rev. comp - BER comp.

AVERAGE CM RATIO, CHOOSING AN
APPROPRIATE SALES MIX

Product A Product B Total

2nd
CM ratio 50 80 130
% Sales 60 40 100

Average CM ratio = CM ration whole comapny = 30% +32% = 62%

Product A Product B Company

Total % Total % Total 62%
Sales 60,000 100% 40,000 100% 100,000
Var. costs 30,000 50% 8,000 20% 38,000
CM 30,000 50% 32,000 80% 62,000
Fixed costs 40,800
Net O.Income 21,200
Break even sales 65,806

Margin of safety 100 - 65,806

= 34,194
 AVERAGE CM RATIO, CHOOSING AN APPROPRIATE
SALES MIX

Product A Product B Total

1st
CM ratio 50 80
% Sales 40% 60% 100% no
no Average CM ratio 20% + 48% = 68% change
change
Product A Product B Company
Total % Total % Total
Sales 40 100 60 100 100
Var. costs 20 50 12 20 38
CM 20 48 80 62
Fixed costs 40,800
Net O.Income 27,200
Break even sales 40,800/ 68% 60
Margin of safety 40
CHOOSING AN APPROPRIATE SALES MIX

Increasing % sales of products with high CM ratio

Average CM ratio is increased

B-E sales is Net income is Mar. of safety

reduced increased is increased

Next period, products with higher CM ratio should come

high on the list of priorities
ASSUMPTIONS OF CVP
ANALYSIS
Assumptions of CVP Analysis

$ $

Price Total
per Cost
Unit

Volume Volume
Selling Price is Constant Variable Cost Per Unit is
Constant
Assumptions of CVP Analysis

Total
Fixed SUVs Car
Costs
2:1
Volume
Fixed Costs are Constant Sales Mix is Constant
Assumptions of CVP Analysis

Units Units
Produced Sold

=
End of Chapter 3
HW:
Sales mix: 5.23
CVP: E5.11; E5.12; E5.14; P5.20; P5.22; P5.25; 5.26
6.12
End of Chapter 3