Cost-Volume-Profit (CVP) Analysis

Introduction
Core Idea
• Constructs a profit model to evaluate scenarios
• Classifies all revenue and cost into volume-related and
non-volume-related groups
• Measure of volume depends on the business
• Units, hours, miles, page views…
• Some costs are variable and increase with volume
• Fixed costs stay the same (over the relevant range)
• Question: How does the volume of business affect revenues,
costs, and profits?
Contribution Margin Formulas
On a per unit basis:

Price P

Variable cost per unit UVC

Contribution margin per unit UCM

Profit = UCM*Q - FC

Contribution margin ratio – CMR For Break-even Set Profit to zero:

Contribution margin/Revenue Break even in Revenue = Fixed Costs/CMR
Contribution margin per unit/price Break even in Units = Fixed Costs/UCM

Margin of Safety:
Budgeted Sales – Break even Sales
Can be expressed in $s or units and often as a % of Budgeted Sales
CVP Model: Graph

Revenues
Total costs

Dollars ($)

Fixed costs

Break-even
volume

Sales Volume
CVP Model
• Once the CVP model is set up, we can use it to answer
questions like:
• At what volume should a company operate in a given time frame to
protect its downside (i.e., not make a loss)?
• At what volume should a company operate in a given time frame to
make a certain desired profit level?
• Would advertising and promotions help?
• Would increasing or decreasing the price help?
Using the CVP Model
• We can also use the CVP model as a “short cut” to visualize the
tradeoff inherent in many decision contexts.
• Helps project profit under “what if” scenarios
• Pricing Increase price, reduce quantity

• Advertising Increase FC, increase quantity

• Outsourcing/automation Tradeoff fixed cost for variable

costs
• Branding/service Increase FC and increase price
CVP—Example
Clarissa sells her cupcakes for $2.50 each. At her current
facility, Clarissa’s variable costs per cupcake equal $0.50 and
her monthly fixed costs are $5,000. How many cupcakes must
Clarissa sell each month to break even?
CVP – capacity constraint
Suppose she can only make 2,000 cupcakes per month at her current facility. Clarissa can hire
space at another kitchen for $500 a month. However, her variable costs per cupcake will be $1.00 in
this new facility. This facility will boost her capacity by another 2,000 cakes per month. 

How many cupcakes must Clarissa sell each month to break even? (or)
What is the minimum volume for the new kitchen to be profitable?
Session 4 Problem 1
• Jeff Jamail’s cookware sets
Cost-Volume-Profit (CVP) Analysis
Incorporating the Effect of Income Taxes
Income Taxes
Taxes are an unavoidable cost of doing business
• Use single tax rate on income for simplicity
Profit after tax (PAT) = profit before tax (PBT) – taxes paid
Taxes paid = tax rate  profit before tax
Profit after tax = (1- tax rate)  profit before tax
= (1- tax rate)  (UCM * Q – FC)
= (1- tax rate)  (CMR * Revenue – FC)
CVP—With Tax
Question: Do income taxes affect the break-even quantity or
sales?
• Clarissa sells her cupcakes for $2.50 each. At her current facility, Clarissa’s
variable costs per cupcake equal $0.50 and her monthly fixed costs are $5,000.
How many cupcakes must Clarissa sell each month to (i) break even? (ii) earn an
after-tax profit of $2,100 if her income is taxed at 30%?
Taxes Change Slope of Profit Line

Taxes

Dollars ($)
Profit after taxes
0
Loss

Loss
Break-even volume

Sales Volume
Let us go to Forrest Gump!
Forrest Gump
“My mama always said life was like
a box of chocolates…

…you never know what you’re gonna get.”

A Box Office Hit?
• From the Viacom Website…
Statistical Information: Fourth Quarter 1994

Movie Update
Days in Box Office Gross
Theatrical
Domestic Release To Date
Forrest Gump (2) 198 $300,565,286
Clear and Present Danger 197 $122,012,079
Star Trek Generations 91 $73,940,367
Nobody's Fool 53 $28,273,852
Drop Zone 69 $27,725,840
I.Q. 53 $25,643,460
Milk Money 156 $18,137,661
Andre 142 $16,820,893
Lassie 161 $9,979,683
The Browning Version 128 $464,423
Pontiac Moon 14 $11,669

Forrest Gump… “There was Dallas, from Phoenix; Cleveland--he was

from Detroit; and Tex--well, I don't remember where Tex come from.”
 An Accounting Hit?
Revenue $191.0
Less Production Costs:
T. Hanks 191*8% 15.3
R. Zemeckis 191*8% 15.3
Misc Production Costs 66.8
Production OH (15.3+15.3+66.8)*15% 14.6 112.0
Gross Margin 79.0
Less SG&A:
“Allocation” Promotion Expenses given 67.2
Advertising 67*10% 6.7
Distribution Fee 191*32% 61.1
TOTAL SGA costs 135.0
Net Income (loss) (56.0)
What is the role for allocations?
• Calculate profit at the individual film level
• For contracting. Tax is often a consideration

• Paramount incurs “overhead” or “capacity” costs

• Need to figure out “fair share” for each film

• The allocation is a way to split up the pie into pieces

identifiable at a smaller unit of analysis (the product level)
Determining contract payments
What level of gross receipts would be needed for Groom to get
a cut under the current contract?
(Let us focus on Paramount’s share of the receipts)

Agreed to…
 Groom (novelist): $350,000 + 3% net profits
 Roth (screenwriter): $<fixed fee> + 5% net
profits

First, what’s variable & fixed? …

CVP Analysis
Revenue $191.0
Less Production Costs:
T. Hanks 191*8% 15.3
R. Zemeckis 191*8% 15.3
Misc Production Costs 66.8
Production OH (15.3+15.3+66.8)*15% 14.6 112.0
Gross Margin 79.0
Less SG&A:
Promotion Expenses given 67.2
Advertising Overhead 67*10% 6.7
Distribution Fee 191*32% 61.1
135.
Net Income (loss) (56)
Recast the income statement
Current
Revenue $ 191.00
Less Variable Costs:
Payment to Tom Hanks 191*8% 15.3
Payment to Bob Zemeckis 191*8% 15.3
Variable Production OH (15.3+15.3)*15% 4.6
Distribution Fee 191*32% 61.1 96.3
Contribution Margin $ 94.74
Less Fixed Costs:
Misc Production Costs 66.8
Fixed Production OH (66.8)*15% 10.0
Promotion Expenses given 67.2
Advertising Overhead 67*10% 6.7 150.7
Net Income (loss) (56.0)
Calculate the Break-even Revenue
• Use the contribution margin ratio (CMR) approach

• CMR =

• Fixed costs =

• Profit =

• Break-even revenue =
CVP Analysis
Current Break-even
Revenue $ 191.00 $ 303.91
Less Variable Costs:
Payment to Tom Hanks 191*8% 15.28
Payment to Bob Zemeckis 191*8% 15.28
Variable Production OH (15.3+15.3)*15% 4.58
Distribution Fee 191*32% 61.12 96.26 153.17
Contribution Margin $ 94.74 $ 150.74
Less Fixed Costs:
Misc Production Costs 66.80
Fixed Production OH (66.8)*15% 10.02
Promotion Expenses given 67.20
Advertising Overhead 67*10% 6.72 150.74 150.74
Net Income (loss) ($56.00) $0.00
Recovering the advance
• Recall that Groom was given an advance of $250,000
upfront.
• So how much revenue must the movie make at the box office
before Groom really gets to see some cash?
Paramount’s perspective
• Variable costs:
• Payments to Hanks, director
• Variable overhead?
• Distribution fee --- this is PROFIT!
• Fixed costs
• Can make variety of assumptions
Paramount BE
• Suppose
• variable overhead is not a “real” cost. That is, it too is an allocation
• Then, BER = $150.7 / 0.84 = $180MM or $360 in Gross Revenue
• Variable OH is a “real” cost for paramount,
• Then BER = $150.7/0.816 = $185 million or $370 in Gross
• We can make similar distinctions re other costs as well
Comparing contracts

Agreed to…
 Groom (novelist): $350,000 + 3% net profits
 Roth (screenwriter): $<fixed fee> + 5% net
profits

 Hanks (actor): 8% of gross revenue

Forrest Gump “Momma always said, ‘Stupid is as stupid does’.”
Is this ethical???

“The accounting department is the

most creative part of Tinseltown.”
(source: HOLLYWOOD PROFITS: GONE WITH THE WIND?,  Cheatham & Davis, CPA Journal, 1996)
 CVP Analysis
So, what happened???

'Forrest Gump' Author Settles With Paramount

 
06/15/1995
(Copyright (c) 1995, Dow Jones & Co., Inc.)

HOLLYWOOD -- Winston Groom, the author of the book on which the hit film "Forrest Gump" was based, last
month retained attorney Pierce O'Donnell because "Forrest Gump" hasn't yet reported any so-called net profits,
despite grossing $341 million in the U.S. Mr. O'Donnell represented writer Art Buchwald in his dispute over the
same issue with Paramount on the movie "Coming to America."

The Alabama writer appears to have settled his differences with Paramount Pictures Corp. which has agreed to
buy a sequel from him. Paramount, a unit of Viacom Inc., purchased the world-wide movie rights to his
coming sequel "Gump & Co." for an undisclosed seven-figure sum.
Evaluating Risk in Cost Structure
Introduction
Evaluating Cost Structure
• Cost structure refers to the mix of fixed and variable costs in
total costs
• When faced with demand uncertainty
• Some companies choose not to get into too many commitments
upfront. They keep fixed costs to a minimum and choose to “pay as
things happen”
• Lower fixed costs and higher variable costs
• Other companies are willing to take more risk by investing in
capacity resources (such as machines, etc.) upfront, but pay less
as things happen
• Higher fixed costs and lower variable costs
Alternate Cost Structures

Cost structure 2
Total costs
Dollars ($)
Cost structure 1

Fixed costs

Crossover volume

Sales Volume ($)

Alternate Cost Structures

Evaluating Cost Structure
• Cost structure can be a strategic choice
• Automation substitutes FC for VC
• Outsourcing substitutes VC for FC
• Increasing the amount of fixed cost increases operating risk, for a
given volume
• Higher variable costs reduce operating risk but also reduce
contribution margin for a given price
• Two measures to evaluate operating risk
• Operating leverage
• Margin of safety
Problem 2: Dan Wenman
• Dan Wenman has approached your bank for a loan to start a hazardous waste management business.
• Dan has two proposals. His first proposal calls for him to “go it alone.” Under this proposal, Dan expects to
incur fixed costs of $1,500,000 per year. His expected contribution margin ratio is 60%.
• The second proposal calls for Dan to outsource the disposal portion of his business (i.e., Dan would focus on
the containment and transportation of waste).The benefit of this option is that it reduces Dan’s fixed costs to
$675,000 per year. The cost, however, is that Dan’s contribution margin ratio would decrease to 30%. Dan is
confident that both options are comparable on all other dimensions, such as quality and safety.
• Regardless of which proposal Dan chooses, he expects his annual revenue to be around $2,750,000.
Problem 2: Profitability of the Two Proposals
   
  Proposal 1 Proposal 2
Expected Revenues
Variable Costs
Contribution Margin
Fixed Costs
Profit Before Taxes

So, which one is better?

Evaluating Operating Risk: Operating Leverage
•Two
  definitions
i. Operating Leverage (OL1) = (book definition)

ii. Operating leverage (OL2) = =

Note: (Elasticity of profit with respect to sales)

Note: OL2 should be interpreted with caution for income close to zero
Evaluating Operating Risk
• At
  a given volume, how much “cushion” does firm have before it starts
making a loss?

• Margin of safety (MOS) is:

• Often expressed as a percentage
• Can be calculated in units
• Can be calculated using sales revenue
• It turns out that MOS = 1/OL2
Problem 2: Expected Sales of $2,750,000
   
  Proposal 1 Proposal 2
Revenues $2,750,000 $2,750,000
Variable Costs 1,100,000 1,925,000
Contribution Margin $1,650,000 $825,000
Fixed Costs 1,500,000 675,000
Profit Before Taxes $150,000 $150,000

OL1
OL2
BE Revenue
MOS
Problem 2: Expected Sales of $4,500,000
   
  Proposal 1 Proposal 2
Revenues $4,500,000 $4,500,000
Variable Costs* 1,800,000 3,150,000
Contribution Margin** $2,700,000 $1,350,000
Fixed Costs 1,500,000 675,000
Profit Before Taxes $1,200,000 $675,000

OL1
OL2
BE Revenue
MOS
Problem 1 - Summary

  Profit Levels
Revenue Levels Proposal 1 Proposal 2
$4,500,000 $1,200,000 $675,000
$2,750,000 150,000 150,000
$2,000,000 ($300,000) ($75,000)
Points to Note
• Operating Leverage (OL) is a measure of the risk in the cost
structure.
• As demand increases, OL decreases.
• For given demand, decisions that increase FC and lower VC
increase OL.
• Profit is more sensitive to volume changes when OL is high.
• At lower demand levels, a cost structure with lower OL is
typically preferred to a cost structure with higher OL.
Business Implications

Operating Leverage
High Low

Financing High
Leverage

Low