Chapter I.

Cost Volume Profit (CVP) Analysis

1.1 Introduction
Cost-volume-profit (CVP) analysis is one of the most powerful tool that help managers
as they make decisions by facilitating quick estimation of net income at different
levels of activity. In other words, it helps them to understand the interrelationship
between cost, volume, and profit in an organization by focusing on interactions
between the following five elements: prices of products, volume or level of activity,
per unit variable costs, total fixed costs, and mix of products sold.
Because CVP analysis helps managers understand the interrelationship between cost,
volume, and profit, it is a vital tool in many business decisions. These decisions
include, for example, what products to manufacture or sell, what pricing policy to
follow, what marketing strategy to employ, and what type of productive facilities to
acquire.

1.2 The Basic of CVP Analysis

Contribution Margin Vs Gross Margin
The form of income statement used in CVP analysis is shown in Exhibit 1.1, i.e., the
projected income statement of Sample Merchandising Company for the month ended
January 31, 20x3. This income statement is called contribution approach to income
statement. The contribution income statement emphasizes the behavior of the costs
and there fore is extremely helpful to manager in judging the impact on profits of
changes in selling price, cost, or volume.

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Exhibit 1.1
Sample Merchandising Company
Projected Income Statement
For the Month Ended January 31,20x3

Total Unit
Sales (10, 000 units) Br. 150, 000 Br.15.00
Variable Expenses 120, 000 12.00
Contribution Margin Br. 30, 000 Br.3.00
Fixed Expenses 24, 000
Net Income Br. 6, 0000

In the income statement here above, sales, variable expenses, and contribution
margin are expressed on a per unit basis as well as in total. This is commonly done on
income statements prepared for management’s own use since it facilitates
profitability analysis.
The contribution margin represents the amount remaining from sales revenue after
variable expenses have been deducted. Thus, it is the amount available to cover fixed
expenses and then to provide profit for the period. Notice the sequence here-
contribution margin is used first to cover the fixed expenses, and then whatever
remains goes toward profit. In the Sample Merchandising Company income statement
shown above, the company has a contribution margin of Br. 30, 000. In this case, the
first Br.24, 000 covers fixed expenses; the remaining Br. 6, 000 represents profit.
The per unit contribution margin indicates by how much birrs the contribution margin
is increased for each unit sold. Sample Merchandising Company’s contribution margin
of Br.3.00 per unit indicates that each unit sold contributes Br.3.00 to covering fixed
expenses and providing for a profit. If the firm had sold 5, 000 units, this would cover
only Br.15, 000 of their fixed expenses (5, 000 units x Br.3.00 per unit). Therefore, the
firm would have a net loss of Br.9, 000.

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 Contribution margin Br.15, 000
Fixed expenses 24, 000
Net loss Br.(9, 000)
If enough units can be sold to generate Br.24, 000 in contribution margin, then all of
the fixed costs will be covered and the company will have managed to show neither
profit nor loss but just cover all of its cost. To reach this point (called break even
point), the company will have to sell 8, 000 units in a month, since each unit sold
yield Br. 3.00 in contribution margin.
Total Per Unit
Sales (8, 000 units) Br.120, 000 Br.15.00
Variable expenses 96, 000 12.00
Contribution margin Br.24, 000 Br.3.00
Fixed expenses 24,000
Net income Br. 0

Computations of the break-even point are discussed in detail later in this unit. For the
moment, note that the break even point can be defined as the point where total sales
revenue equals total expenses (variable plus fixed) or as the point where total
contribution equals total fixed expenses.

Too often people confuse the terms contribution margin and gross margin. Gross
margin (which is also called gross profit) is the excess of sales over the cost of goods
sold (that is, the cost of the merchandise that is acquired or manufactured and then
sold). It is a widely used concept, particularly in the retailing industry.
Contribution Margin Ratio (CM-Ratio)
In addition to being expressed on a per unit basis, revenue, variable expenses, and
contribution margin for Sample Merchandising Company can also be expressed on a
percentage basis:
Total Per Unit Percentage
Sales (8, 000 units) Br.150, 000 Br.15.00 100%
Variable expenses 120, 000 12.00 80%

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Contribution margin Br.30, 000 Br.3.00 20%
Fixed expenses 24,000
Net income Br. 6, 000
The percentage of the contribution margin to total sales is referred to as the
contribution margin ratio (CM-ratio). This ratio is computed as follows:
CM-ratio= Contribution Margin
Sales
Contribution margin ratio = 1 – variable cost ratio. The variable-cost ratio or
variable-cost percentage is defined as all variable costs divided by sales. Thus, a
contribution margin of 20% means that the variable-cost ratio is 80%.
In the example here below, the contribution margin percent or contribution margin
ratio, also called profit/volume ratio (p/v ratio) is 20%. This means that for each birr
increase in sales, total contribution margin will increase by 20 cents (Br.1 sales x CM
ratio of 20%). Net income will also increase by 20 cents, assuming that there are no
changes in fixed costs.
As this illustration suggests, the impact on net income of any given birr change in
total sales can be computed in seconds by simply applying the contribution margin
ratio to birr change.
Once the break-even point has been reached, net income will increase by the unit
contribution margin for each additional unit sales. If 8001 units are sold in a month,
for example, then we can expect that the Sample Merchandising Company’s net
income for the month will be Br. 3, since the company will have sold 1 unit more than
the number needed to break even:
Total Per Unit
Sales (8, 000 units) Br.120, 015 Br.15.00
Variable expenses 96, 012 12.00
Contribution margin Br.24, 003 Br.3.00
Fixed expenses 24,000
Net income Br. 3
If 8002 units are sold (2 units above the break even point), then we can expect that
the net income for the month will be Br.9, and so forth.

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1.3 Break even Analysis
The study of cost-volume-profit analysis is usually referred as break-even analysis.
This term is misleading, because finding break-even point is often just the first step in
planning decision. CVP analysis can be used to examine how various alternatives that
a decision maker is considering affect operating income. The break-even point is
frequently one point of interest in this analysis
Break-even point can be defined as the point where total sales revenue equals total
expenses, i.e., total variable cost plus total fixed costs. It is a point where the total
contribution margin equals total fixed expenses. Stated differently, it is a point where
the operating income is zero.
Equation Technique: It is the most general form of break-even analysis that may be
adapted to any conceivable cost-volume-profit situation. This approach is based on
the profit equation. Income (or profit) is equal to sales revenue minus expenses. If
expenses are separated into variable and fixed expenses, the essence of the income
statement is captured by the following equation.
Profit= Sales revenue-Variable expenses-Fixed expenses
Profit (net income) is the operating income plus non-operating revenues (such as
interest revenue) minus non-operating costs (such as interest cost) minus income
taxes. For simplicity, throughout this unit non-operating revenues and non-operating
cost are assumed to be zero. Thus, the above formula can be restated as follows
Profit (Net income) =(P XQ)-(VxQ)-F NI=(P XQ)-(VxQ)-F
where P=sales price
Q=break-even unit sales
V= variable expenses per unit
F=fixed expenses per period
NI= net income
At break-even point, net income=0 because total revenue equal total expenses.
That is, NI=PQ-VQ-F
0= PQ-VQ-F……………………………………equation (1)
Contribution-Margin Technique. The contribution margin technique is merely a short version of the
equation technique. The approach centers on the idea that each unit sold provides a certain amount of fixed

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costs. When enough units have been sold to generate a total contribution margin equal to the total fixed
expenses, break-even point (BEP) will be reached. Thus, one must divide the total fixed costs by the
contribution margin being generated by each unit sold to find units sold to break-even.

BEP= Fixed expenses

Unit contribution margin
Given the equation for net income, you can arrive at the above short cut formula for
computing break-even sales in units as follows:
NI=PQ-VQ-F
0=Q (P-V)-F because at BEP net income equals zero.
Q (P-V)=F…divide both sides by (p-v)
Q= F ………………….…. equation (2)
P-V
There is a variation of this method that uses the CM ratio of the unit contribution
margin. The result is the break-even point in total sales birrs rather than in total units
sold.
BEP (in sales birrs)= Fixed expenses = F
CM ratio P-V
P
This approach to break-even analysis is particularly useful in those situations where a
company has multiple product lines and wishes to compute a single break-even point
for the company as a whole. More is said on this point in later section titled Sales Mix
and CVP Analysis.
The contribution- margin and equation approaches are two equivalent techniques for
finding the break-even point. Both methods reach the same conclusion, and so
personal preference dictates which approach should be used.

Graphical Method: In the graphical method we plot the total costs and revenue lines
to obtain their point of intersection, which is the breakeven point.

Total costs line. This line is the sum of the fixed costs and the variable costs. To plot
fixed costs, draw a line parallel to the volume axis. To plot the total cost line, choose
some volume of sale and plot the point representing total expenses (fixed and
variable) at the activity level you have selected. After the point has been plotted,

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draw a line through it back to the point where the fixed expense line intersects the
birrs axis (the vertical axis).
Total Revenue Line: Again choose some volume of sales to construct the revenue
line and plot the point representing total sales birrs at the activity you have selected.
Then draw a line through this point back to the origin.
The break-even point is where the total revenues line and the total costs line
intersect. This is where total revenues just equal total costs.

1.4 Applying CVP Analysis

1.4.1 Sensitivity “What If” Analysis
Sensitivity analysis is a “what if” technique that examine how a result will change if
the original predicted data are not achieved or if an underlying assumption changes.
In the context of CVP, sensitivity analysis answers such questions as, what will
operating income be if the out put level decreases by a given percentage from the
original reduction? And what will be operating income if variable costs per unit
increase? The sensitivity analysis to various possible outcomes broadens managers’
perspectives as to what might actually occur despite their well-laid plans.
Example (1) Zena Concepts, Inc., was founded by Zemenu Adugna, a graduate
student in engineering, to market a radical new speaker he had designed for
automobiles sound system. The company’s income statement for the most recent
month is given below:
Total Per Unit
Sales (6400 speakers) Br.100, 000 Br.250
Variable expenses 60, 000
150
Contribution margin 40, 000 Br.100
Fixed expenses 35, 000
Net income Br.5, 000
Yohannes Tilahun, the senior accountant at Zena Concepts, wants to demonstrate
the company’s president how the concepts developed on the preceding pages can be
used in planning and decision-making. To this end, Yohannes will use the above data

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to show the effects of changes in variable costs, fixed costs, sales, and sales volume
on the company’s profitability.
Changes in Fixed Costs and Sales Volume: Zena Concepts is currently selling 400
speakers per month (monthly sales of Br.100, 000). The sales manager feels that a
Br.10, 000 increase in the monthly advertising budget would increase monthly sales
by Br.30, 000. Should the advertising budget be increased?
Changes in Variable Costs and Sales Volume: Refer to the original data.
Management is contemplating the use of high- quality components, which would
increase variable costs by Br.10 per speaker. However, the sales manager predicts
that the higher overall quality would increase sales to 480 speakers per month.
Should the higher quality component be used?
Change in Fixed Cost, Sales Price, and Sales Volume. Refer to the original data
and recall that the company is currently selling 400 speakers per month. To increase
sales, the sales manager would like to cut selling price by Br 20 per speaker and
increase the advertising budget by Br 15, 000 per month. The sales manager argues
that if these two steps are taken, unit sales will increase by 50%. Should the change
be made?
Changes in Variable Cost, Fixed Cost, and Sales Volume: Refer to the original
data. The sales manager would like to replace the sales staff on a commission basis of
Br 15 per speaker sold, rather than on flat salaries that now total Br 6, 000 per month.
The sales manager is confident that the change will increase monthly sales by 15%.
Should the change be made?
Changes in Regular Sales Price: Refer the original data. The company has an opportunity to make bulk
sales of 150 speakers to wholesalers if an acceptable price can be worked out. This sale would not disturb
the company’s regular sales. What price per speaker should be quoted to the wholesaler if Zena Concepts
wants to increase its monthly profits by Br 3, 000?
1.4.2 Target Net Profit Analysis
Managers can also use CVP analysis to determine the total sales in units and birrs
needed to reach a target profit.
The method used for computing desired or targeted sales volume in units to meet the
desired or targeted net income is the same as was used in our earlier breakeven
computation.

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 Example (1) Tantu Company manufactures and sales a single product. During the
year just ended the company produced and sold 60,000 units at an average price of
Br.20 per unit. Variable manufacturing costs were Br 8 per unit, and variable
marketing costs were Br 4 per unit sold. Fixed costs amounted to Br. 180,000 for
manufacturing and Br.72, 000 for marketing. There was no year-end work-in-progress
inventory. Ignore income taxes.
Instructions:
a) Compute Tantu’s breakeven point (BEP) in sales birrs for the year.
b) Compute the number of sales units required to earn a net income of Br 180,000
during the year
c) Tantu’s variable manufacturing costs are expected to increase 10 % in the
coming year. Compute the firm’s breakeven point in sales birrs for the coming
year.
d) If Tantu’s variable manufacturing costs do increase 10 %, compute the selling
price that would yield the same CM-ratio in the coming year.
1.4.3. The Margin of Safety
The margin of safety is the excess of budgeted (or actual) sales over the breakeven
volume of sales. It states the amount by which sales can drop before losses begin to
be incurred. In other words, it is the amount of sales revenue that could be lost before
the company’s profit would be reduced to zero. The formula for its calculations
follows:
Total sales - Break even Sales = Margin of safety
The margin of safety can also be expressed in percentage form. This percentage is
obtained by dividing the margin of safety in birr terms by total sales:
Margin of safety in birrs = Margin of safety ratio
Total sales
Example (1): Consider the cost structure for ABC Company and XYZ in Exhibit 5-2
ABC Co. and XYZ Co.
Comparative Cost Structures
ABC Co. XYZ Co.
Amount Perce Amount Perce
nt nt

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 Sales Br. 100 Br. 100
500,000 500,000
Variable costs 100,00 20 300,0 60
0 00
Contribution Margin 400,00 80 200,0 40
0 00
Fixed costs 300,00 100,0
0 00
Net income Br. Br.
100,000 100,000
Compute the break even sales and the margin of safety for each company

1.5 The Impact of Income Tax on CVP Analysis

Thus far we have ignored income taxes. However, profit-seeking enterprises must pay
income taxes on their profits. A firm’s net income after tax, the amount of income
remaining after subtracting the firm’s income- tax expense, is less than its before- tax
income. This fact is expressed in the following formula:
NIAT = NIBT (1 – tax rate)
Where NIAT = net income after taxes
NIBT=net income before taxes
The requirement that companies pay income taxes affects their CVP relationships. To
earn a particular after-tax net income will require greater before-tax income than if
there were no tax.
Example (1) Hydro System Engineering Associates, Inc. provides consulting services
to city water authorities. The consulting firm’s contribution margin ratio is 20%, and
its annual fixed expenses are Br. 120, 000. The firm’s income-tax rate is 40%.
Instructions:
a. Calculate the firm’s break-even volume of service revenue.
b. How much before-tax income must the firm earn to make an after-tax net
income of Br. 48, 000?

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 c. What level of revenue for consulting services must the firm generate to earn an
after-tax income of Br.48, 000?
d. Suppose the firm’s income-tax rate rises to 45 percent. What will happen to
break-even level of consulting service revenue?

1.6 CVP Analysis with Multiple Products

1.6.1 Definition of Sales Mix

The term sales mix (also called revenue mix) is defined as the relative proportions or
combinations of quantities of products that comprise total sales. If the proportions of
the mix change, the CVP relationships also change. Thus, managers try to achieve the
combination, or mix, that will yield the greatest amount of profit.

A shift in sales-mix from high-margin items to low-margin items can cause total profits
to decrease even though total sales may increase. Conversely, a shift in the sales mix
from low margin items to high-margin items can cause the reverse effect-total profit
may increase even though total sales decrease.

1.6.2 Sales Mix and CVP Analysis

To this point the discussion on CVP analysis focused on a firm that sells a single
product; such a firm is generally unrealistic, existing only in the minds of textbook
writers. This section of the unit examines the usefulness of the CVP technique for
firms that deal in several products. In the general case the CVP equation could be
presented as:
P1Q1 + P2Q2+...+PnQn – V1Q1 – V2Q2-...VnQn-FC = NI
Where Pi = Selling price per unit of product i
Qi = Number units of i produced and sold
Vi = Unit variable cost of product i
FC = Fixed Cost per Period
NC = Net Income
In a multi product firm, break-even analysis is somewhat more complex. The reason is
that different products will have different selling prices, different costs, and different
contribution margins.

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Using contribution margin approach, the computation of the break-even point (BEP) in
multi product firm follows:
BEP (in units) = Total fixed expenses
Weighted average CM
BEP (in birrs) = Total Fixed Expenses
CM – ratio
Weighted average unit contribution margin is the average of the several products’
unit contribution margins, weighted by the relative sales proportion of each product.
For a company manufacturing and selling three products (X, Y and Z), with sales of
mix of n1,n2 and n3, respectively, the break even point may be given by the following
short cut formula:
BEP (in units) = Total fixed costs
cm1n1 + cm2n2 + cm3n3
n1 + n2 + n3

Where cmi = Unit contribution margin for product i.

To prove the above formula, let us begin with general CVP equation for a company
producing three products.
NI = P1Q1 + P2Q2 + P3Q3 - V1Q1 – V2Q2 – V3Q3 – FC
Where NI = income
Pi = Unit sales price for product i
Qi = Sales volume for product
Vi = Unit variable cost for product i
FC = Fixed cost per period
The difference between total sales and total variable costs for each product, i.e. PiQi –
ViQi, equals their total contribution margin (TCM). The above general formula can be
restated as follows:
NI = TCM1 + TCM2 + TCM3 – FC
0 = TCM1 + TCM2 + TCM3 – FC (NI equals at BEP)
0 = CM1Q1 + CM2Q2 + CM3Q3 – FC
Where CMi =contribution margin per unit for product i
Qi = sales volume for product i to break even

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Given the sales mix X: Y: Z = n1: n2 : n3, and assuming that the company break-even
at “Q” units, then
0 = CMn1 Q + CM2n2 Q + CM3n3 Q
– FC
n1 + n2 + n3 n1 + n2 + n3 n1 +
n2 + n3

0= Q (Cm1n1 + Cm2n2 + Cm3n3) – FC

n1 + n2 + n3

FC= Q (Cm1n1 + Cm2n2 + Cm3n3)

n1 + n2 + n3

Q (Cm1n1 + Cm2n2 + Cm3n3) = FC (n1 + n2 + n3)

Q= FC (n1 + n2 + n3)
Cm1n1 + Cm2n2 + Cm3n3

Q= FC …………….. equation (1)

Cm1n1 + Cm2n2 + Cm3n3
n1 + n2 + n3
Here in equation (1), the denominator, Cm1n1 + Cm2n2 + Cm3n3, is the weighted
average
n1 + n2 + n3
contribution margin.
Similarly, the company’s break-even sales in birrs would be calculated as
BEP (in birrs) = Fixed expenses
CM – ratio
= Fixed expenses
Average CM
Average Sales Price
= Fixed expenses
Cm1n1 + Cm2n2 + Cm3n3
n1 + n2 + n3
P1n1 + P2n2 + P3n3
n1 + n2 + n3
BEP (in birrs) = Fixed expenses …………….. equation (2)
Cm1n1 + Cm2n2 + Cm3n3
p1n1 + p2 n2 + p3n3
Here in equation (2), the denominator represents the contribution margin ratio.

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Example (1) Topper Sports, Inc. produces high-quality sports equipment. The
company’s Racket Division manufactures three tennis rackets – the Standard, the
Deluxe, and the Pro- that are widely used in amateur play. Selected information on
the rackets is given below:

Pro
Standard Deluxe
Selling price per racket Br. 40.00 Br. 60.00 Br.
75.00
Variable expenses per racket:
Production 22.00 27.00 40.45
Selling (5% of selling price) 2.00 3.00 3.75

All sales are made thorough the company’s own retail outlets. The Racket Division has
the following fixed costs:
Per Month
Fixed production costs………………………….Br. 120, 000
Advertising expenses…………………………… 100, 000
Administrative salaries…………………………. 50, 000
Total Br.270, 000
Sales, in units, for the month of May have been as follows:
Standard Deluxe Pro Total
Sales in units………… 2, 000 1, 000 5, 000 8, 000

Instructions:
a. Compute the weighted- average unit contribution margin, assuming
the above sales mix is maintained.
b. Compute the Racket Division’s break-even point in birrs for May.
c. How many units of each product should the company sale in order to
earn a Br.162, 000 incomes? Ignore income taxes.
Example (2) Addis Marine Products Inc. plans to manufacture and sell accessories for
recreational fishing craft and pleasure boats. Three of the principal product lines are
manufactured at the Awassa plant. Operating data for the coming year is estimated
as follows:

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 Product Lines

Ethio-01 Ethio-02 Ethio-03

Sales price Br.150 Br.80 Br.40
Variable costs 100 60 10
Units sales 3, 200 units 1, 600 units 4, 800 units
The total annual fixed cost on the three-product lines amount to Br. 840,000
Instructions:
a) Assuming the above sales mix, determine the BEP (break-even point) for Addis
Company during the coming year. Also determine the number of units of each
product that should be sold to break even in units and in birrs.
b) What volume of sales in birrs for each product must Addis Marine Products Inc.
achieve to earn a net income of Br. 73,500 after taxes in the coming year?
Assume the company is subject to a 30% income tax rate.
c) Calculate the total sales volume in units and in birrs for each product so that
Addis Company achieves 8.4% return on sales.
d) Suggest any other alternative sales mix that can lower the Company’s BEP in
units holding the unit selling price, the unit variable cost and the total annual
fixed costs constant.

1.7 Underlying Assumptions in CVP Analysis

For any CVP analysis to be valid, the following important assumptions must be
reasonably satisfied within the relevant range.
1. Costs are linear (straight-line) through the entire relevant range, and they
can be accurately divided into two variable and fixed elements. This implies
the following more specific assumptions.
a. Total fixed expenses remain constant as activity changes, and the
unit variable expense remains unchanged as activity varies.

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 b. The efficiency and productivity of production process and workers
remain constant.
2. The behavior of total revenue is linear (straight-line). This implies that the
price of the product or service will not change as sales volume varies within
the relevant range.
3. In multi product companies, the sales mix remains constant over the relevant
range.
4. In manufacturing firms, inventories does not change, i.e., the inventory level
at the beginning and end of the period are the same. This implies that the
number units produced during the period equals the number of units sold.
5. The value of a birr received today is the same as the value of a birr received in
any future year.

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