CHAPTER – 4

COST-VOLUME-PROFIT RELATIONSHIPS
Cost-volume-profit (CVP) analysis
Cost-volume-profit (CVP) analysis is a powerful tool that helps managers understand the
relationships among cost, volume, and profit.
CVP analysis focuses on how profits are affected by the following five factors:
1. Selling prices.
2. Sales volume.
3. Unit variable costs.
4. Total fixed costs.
5. Mix of products sold.
It is a vital tool in many business decisions including:
➢ what products and services to offer,
➢ what prices to charge,
➢ what marketing strategy to use, and
➢ what cost structure to implement.

THE BASICS OF CVP ANALYSIS

Contribution Margin
Contribution margin is the amount remaining from sales revenue after variable expenses
have been deducted.
✓ It is the amount available to cover fixed expenses and then to provide profits for
the period.
✓ If the contribution margin is not sufficient to cover the fixed expenses, then a loss
occurs for the period.
Example:

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CVP Relationships in Equation Form
The contribution format income statement can be expressed in equation form as follows:
Profit = (Sales - Variable expenses) - Fixed expenses

Sales = Selling price per unit × Quantity sold = P × Q

Variable expenses = Variable expenses per unit × Quantity sold = V × Q
Profit = (P × Q - V × Q) - Fixed expenses

CVP Relationships in Graphic Form

A CVP graph (sometimes called a break-even chart), highlights CVP relationships over
wide ranges of activity.
In a CVP graph
✓ Unit volume is represented on the horizontal (X) axis and
✓ Dollars on the vertical (Y) axis.

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Contribution Margin Ratio (CM Ratio)
The contribution margin as a percentage of sales is referred to as the contribution
margin ratio (CM ratio).
This ratio is computed as follows:

or,

VARIABLE EXPENSE RATIO

The variable expense ratio is the ratio of variable expenses to sales.
It can be computed by dividing the total variable expenses by the total sales, or in a
single product analysis, it can be computed by dividing the variable expenses per unit by
the unit selling price.

Target Profit and Break-even analysis

Target Profit Analysis
One of the key uses of CVP analysis is called target profit analysis. In target profit
analysis, we estimate what sales volume is needed to achieve a specific target profit.

The Equation Method

We can use a basic profit equation to find the sales volume required to attain a target
profit.

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The Formula Method
We can compute the sales volume required to attain a specific target profit using the
following formula:

Break-Even Analysis
Break-even analysis is really just a special case of target profit analysis in which the
target profit is zero.

Break-Even in Unit Sales

The Margin of Safety

The margin of safety is the excess of budgeted (or actual) sales dollars over the break-
even volume of sales dollars. It is the amount by which sales can drop before losses are
incurred. The higher the margin of safety, the lower the risk of not breaking even and
incurring a loss.
The formula for the margin of safety is:

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Operating Leverage
Operating leverage is a measure of how sensitive net operating income is to a given
percentage change in dollar sales.
• Operating leverage acts as a multiplier.
• If operating leverage is high, a small percentage increase in sales can produce a
much larger percentage increase in net operating income

The degree of operating leverage at a given level of sales is computed by the following
formula:

ASSUMPTIONS OF CVP ANALYSIS

A number of assumptions commonly underlie CVP analysis:
1. Selling price is constant. The price of a product or service will not change as
volume changes.
2. Costs are linear and can be accurately divided into variable and fixed elements.
3. The variable element is constant per unit, and the fixed element is constant in total
over the entire relevant range.
3. In multi-product companies, the sales mix is constant.
4. In manufacturing companies, inventories do not change. The number of units
produced equals the number of units sold.

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PROBLEM – 1
Platinum Company manufactures and sells a telephone answering machine. The
company’s contribution income statement for the most recent year is given below:
Total Per Unit Percent
(Tk) (Tk.) of Sales
Sales (20,000 units) 1,200,000 60 100%
Less: Variable expenses 900,000 45 ?%
Contribution margin 300,000 15 ?%
Less: Fixed expenses 240,000
Net Income 60,000

Management is anxious to improve the company’s profit performance and has asked for
several items of information.
Required:
a) Compute the company’s CM ratio and variable expense ratio.
b) Compute the company’s break-even point in both units and sales Taka. Use
both the equation and unit contribution method.
c) Assume that sales increase by Tk.400,000 next year. If cost behavior
patterns remain unchanged, by how much will the company’s net income
increase? Use the CM ratio to determine your answer. Verify your answer
by preparing a contribution income statement.
d) Refer to original data. Assume that next year management wants the
company to earn a minimum profit of Tk.90,000. How many units will have
to be sold to meet this target profit figure?
e) Refer to the original data. Compute the company’s margin of safety in both
Taka and percentage form.
f) (i) Compute the company’s degree of operating leverage at the
present level of sales.
(ii) Assume that trough a more intense effort by the sales staff the
company’s sales increase by 8% next year. By what percentage
would you expect the net operating income to increase? Use the
operating leverage concept to obtain your answer.
(iii) Verify your answer to (ii) by preparing a new income statement
showing an 8% increase in sales.

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 g) In an effort to increase sales and profits, management is considering the use
of a higher quality speaker. The higher quality speaker would increase
variable costs by Tk.3 per unit, but management could eliminate one quality
inspector who is paid a salary of Tk.30,000 per year. The sales manager
estimates that the higher quality speaker would increase annual sales by at
least 20%.
i. Assuming that changes are made as described above, prepare a
projected income statement for next year. Show data on a total, per
unit, and percentage basis.
ii. Compute the company’s new break-even point in both units and Taka
sales. Use the contribution margin method.
iii. Would you recommend that the changes be made?

PROBLEM – 2
Menlo Company distributes a single product. The company’s sales and expenses for last
month follow:

Required:
(a) What is the monthly break-even point in units sold and in sales dollars?
(b) Without resorting to computations, what is the total contribution margin at the
break-even point?
(c) How many units would have to be sold each month to earn a target profit of
$90,000? Use the formula method. Verify your answer by preparing a
contribution format income statement at the target sales level.
(d) Refer to the original data. Compute the company’s margin of safety in both dollar
and percentage terms.

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 (e) What is the company’s CM ratio? If sales increase by $50,000 per month and
there is no change in fixed expenses, by how much would you expect monthly net
operating income to increase?

PROBLEM – 3
Fill in the missing amounts in each of the case situations below. Each case is independent
of the others.
(a)

(b)

PROBLEM – 4
Outback Outfitters sells recreational equipment. One of the company’s products, a small
camp stove, sells for $50 per unit. Variable expenses are $32 per stove, and fixed
expenses associated with the stove total $108,000 per month.
Required:
(a) Compute the break-even point in number of stoves and in total sales dollars.
(b) If the variable expenses per stove increase as a percentage of the selling price,
will it result in a higher or a lower break-even point? Why? (Assume that the
fixed expenses remain unchanged.)

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 (c) At present, the company is selling 8,000 stoves per month. The sales manager is
convinced that a 10% reduction in the selling price would result in a 25% increase
in monthly sales of stoves. Prepare two contribution format income statements,
one under present operating conditions, and one as operations would appear after
the proposed changes. Show both total and per unit data on your statements.
(d) Refer to the data in (c) above. How many stoves would have to be sold at the new
selling price to yield a minimum net operating income of $35,000 per month?

PROBLEM – 5
Your University is planning its annual Feast. The feast organizing committee has
assembled the following expected costs for the event:
Dinner (per person) . . . . . . . . . . . . . . . . Tk.1,800
Snacks (per person) . . . . . . . . . . . . . . . . Tk. 200
Rental of hall room . . . . . . . . . . . . . . . . Tk. 250,000
Beautification . . . . …………………... Tk. 200,000
Printing & Press . . . . . . . . . . . . . . . . . . . Tk. 150,000
The committee members would like to charge Tk. 3,500 per person for the evening’s
activities.
Required:
(a) Compute the break-even point (in terms of the number of persons who must
attend).
(b) Assume that last year only 300 persons attended the Program. If the same number
attend this year, what price per ticket must be charged in order to break even?
(c) Refer to the original data. Prepare a CVP graph from zero tickets up to 600 tickets
sold.

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