CVP Analysis

How can managers of 6Ten stores see the effects of selling a

new flavor of milk during the morning rush hour,
increasing milk prices, or opening stores in a new area?

Cost-volume-profit (CVP) analysis examines the behavior of

total revenues, total costs, and operating income
as changes occur in
- the output level,
- the selling price,
- the variable cost per unit, and/or
- fixed costs of a product
Managers use CVP analysis to help answer questions such
as:
- How will total revenue and total costs be affected if the
output level changes?
- If we raise or lower selling price, how will that affect the
output level?
- If we expand our business into foreign markets, how will
that affect costs, selling price, and output level?
CVP assumptions:
- Changes in the levels of revenue and costs arise only
because of changes in the number of product/service
units produced and sold.
The number of output units is the only revenue driver and
the only cost driver
- Total costs can be separated into a fixed component and
a variable component
- When represented graphically, the behaviours of total
revenues and total costs are linear in relation to output
level within a relevant range and time period
- Selling price, vc per unit and fixed costs in total are known
and constant
CVP assumptions:
- The analysis either covers a single product or assumes
that the proportion of different products when multiple
products are sold will remain constant as the level of total
units sold changes
- All revenues and costs can be added and compared
without taking into account the time value of money
- Operating income = total revenues from operations – cost
of goods sold and operating costs

- Net income is operating income plus non-operating

revenues (such as interest income) minus non-operating
costs (such as interest cost) minus income taxes

- Net income = operating income + non-operating revenues

– non-operating costs – income taxes
Mamta plans to sell Do-All Software, a home-office software
package, at a two-day computer convention in
Ahmedabad. Mamta can purchase this software from a
computer software wholesaler at Rs.120 per package,
with the privilege to return all unsold packages and
receive a full Rs.120 refund per package. The package will
be sold for Rs.200 each. She has already paid Rs.2,000 to
Computer Conventions for the booth rental for the two-
day convention. Assume that there are no other costs.

Booth rental cost of Rs.2,000 is a fixed cost

The cost of the package Rs.120 is a variable cost
The difference between total revenues and total variable
costs is called contribution margin

Contribution margin = total revenues – total variable costs

Contribution margin per unit

= selling price – variable costs per unit

Contribution margin
= contribution margin per unit * number of units sold
 0 1 5 25 40
Revenues at Rs.200 per package Rs.0 Rs.200 Rs.1,000 Rs.5,000 Rs.8,000
Variable costs at Rs.120 per package 0 120 600 3,000 4,800
CM at Rs.80 per package 0 80 400 2,000 3,200
Fixed costs 2,000 2,000 2,000 2,000 2,000
Operating income (2,000) (1,920) (1,600) 0 1,200
CM percentage (CM ratio) / PV ratio
= CM per unit / selling price OR
= total CM / total revenue

CM percentage = 80 / 200 = 0.40 or 40%

Breakeven Point (BEP)
Quantity of output sold at which total revenues equal total
costs
Quantity of output sold at which operating income is 0
BEP tells managers how much output they must sell to avoid
a loss
Breakeven Point (BEP)
Revenue – Total Costs = Operating Income
Revenue – VC – FC = OI
(SP * Q) – (VCU * Q) – FC = OI
(SP * Q) – (VCU * Q) = FC + OI
(SP – VCU) Q = FC + OI
Q = (FC + OI) / (SP – VCU)
Q = (FC + OI) / CMU
At BEP, operating income is 0
Q = FC / CMU

Breakeven number of units = fixed costs / CM per unit

Breakeven Point (BEP)
Breakeven number of units = fixed costs / CM per unit
Breakeven number of units = 2,000 / 80 = 25 packages

25
Revenues at Rs.200 per package Rs.5,000
Variable costs at Rs.120 per package 3,000
CM at Rs.80 per package 2,000
Fixed costs 2,000
Operating income 0
Breakeven Point (BEP)
Breakeven Revenues
= FC / CM %
= 2,000 / 0.40
= Rs.5,000
Breakeven Chart
Operating
Total Revenue
income

BEP = 25 Total Cost

units
Rs.2,000
Breakeven
Revenue
VC
Rupees

FC

FC

25 units

Operating Units sold

loss
Target Operating Income
How many units must be sold to earn an operating income
of Rs.1,200
(SP * Q) – (VCU * Q) – FC = OI
(200 * Q) – (120 * Q) – 2,000 = 1,200
200 Q – 120 Q = 3,200
Q = 3,200 / 80 = 40 units or packages
Desired sales to earn target OI = (FC + TOI) / CMU
= (2,000 + 1,200) / 80
= 40 units
Revenue needed to earn TOI = (FC + TOI) / CM%
= (2,000 + 1,200) / 0.40
= Rs.8,000
Target Operating Income
40
Revenues at Rs.200 per package Rs.8,000
Variable costs at Rs.120 per package 4,800
CM at Rs.80 per package 3,200
Fixed costs 2,000
Operating income 1,200
Target Net Income
How many units must be sold to earn a net income of
Rs.960?
Revenue – VC – FC = OI
Target Net Income = OI – Income Tax
Target NI = OI – (OI * tax rate)
Target NI = OI (1 – tax rate)
OI = target NI / (1 – tax rate)
Revenue – VC – FC = target NI / (1 – tax rate)
SP * Q – VC * Q – FC = target NI / (1 – tax rate)
200 Q – 120 Q – 2,000 = 960 / (1 – 0.40)
80 Q – 2,000 = 1,600
Q = 3,600 / 80 = 45 units
Target Net Income

TNI
FC +
1 – tax rate
Q =
CMU

960
2,000 +
1 – 0.40
Q =
80
= 45 units
Target Net Income

TNI
FC +
Desired 1 – tax rate
revenue =
CM %

960
2,000 +
1 – 0.40
Q =
o.40
= Rs.9,000
Target Net Income
45
Revenues at Rs.200 per package Rs.9,000
Variable costs at Rs.120 per package 5,400
CM at Rs.80 per package 3,600
Fixed costs 2,000
Operating income 1,600
Income tax @ 40% 640
Net income 960

What will be effect on BEP when focusing the analysis on

target net income instead of target operating income?
Using CVP Analysis for decision making
Different choices can affect selling prices, VC per unit, FC,
units sold, and OI
CVP Analysis helps managers make this decision by
estimating the expected long-term profitability of
different choices
CVP Analysis also helps managers decide
how much to advertise
whether to expand into new market
how to price the product
CVP Analysis evaluates how OI will be affected if the original
predicted data are not achieved
Decision to advertise
Suppose Mamta anticipates to sell 40 units
At a sale of 40 units, Mamta’s OI would be Rs.1,200
Mamta is considering placing an advertisement in
Ahmedabad Mirror describing the product, its features,
and her participation in Computer Conventions
The advertisement will cost Rs.500
She anticipates that advertising will increase sales by 10% to
44 packages
Should Mamta advertise?
Decision to advertise
40 44
Revenues at Rs.200 per package Rs.8,000 Rs.8,800
Variable costs at Rs.120 per package 4,800 5,280
CM at Rs.80 per package 3,200 3,520
Fixed costs 2,000 2,500
Operating income 1,200 1,020

40 44 Difference
CM at Rs.80 per package Rs.3,200 Rs.3,520 Rs.320
Fixed costs 2,000 2,500 500
Operating income 1,200 1,020 (180)
Decision to reduce selling price
Having decided not to advertise, Mamta is contemplating
whether to reduce selling to Rs.175
At this price she anticipates to sell 50 units
At this quantity, the software whole-seller who supplies Do-
All Software will sell packages to Mamta for Rs.115 per
unit instead of Rs.120
Should Mamta reduce the selling price?
New CM per unit= 175 – 115 = Rs.60
CM from lowering selling price 50 units * Rs.60 Rs.3,000
Original CM 40 units * Rs.80 Rs.3,200
Change in CM from lowering selling price (Rs.200)
Decision to reduce selling price
Mamta can examine other alternatives to increase OI
Such as,
Simultaneously increasing advertising costs and lowering
prices
In each case, she will compare the changes in CM (through
the effects on SP, VC and quantities of units sold) to the
changes in FC
Alternative FC & VC structures
Suppose Computer Conventions offers Mamta three rental
alternatives:
Option 1 Rs.2,000 fixed fee
Option 2 Rs.800 fixed fee plus 15% of convention
revenues
Option 3 25% of convention revenues with no fixed fee
Option # 1
0 16 20 25 40 60
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
Revenues at 0 3,200 4,000 5,000 8,000 12,000
Rs.200 per package
Variable costs at 0 1,920 2,400 3,000 4,800 7,200
Rs.120 per package
CM at Rs.80 0 1,280 1,600 2,000 3,200 4,800
per package
Fixed costs 2,000 2,000 2,000 2,000 2,000 2,000
Operating income (2,000) (720) (400) 0 1,200 2,800
Option # 2
Selling price Rs.200
VC PU= purchase price 120 + rent 15% of revenue
VC PU = 120 + 20 = Rs.150
FC Rs. 800
0 16 20 25 40 60
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
Revenues at 0 3,200 4,000 5,000 8,000 12,000
Rs.200 per package
Variable costs at 0 2,400 3,000 3,750 6,000 9,000
Rs.150 per package
CM at Rs.50 0 800 1,000 1,250 2,000 3,000
per package
Fixed costs 800 800 800 800 800 800
Operating income (800) 0 200 450 1,200 2,200
Option # 3
Selling price Rs.200
VC PU= purchase price 120 + rent 25% of revenue
VC PU = 120 + 50 = Rs.170
FC Rs. 0
0 16 20 25 40 60
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
Revenues at 0 3,200 4,000 5,000 8,000 12,000
Rs.200 per package
Variable costs at 0 2,720 3,400 4,250 6,800 10,200
Rs.170 per package
CM at Rs.30 0 480 600 750 1,200 1,800
per package
Fixed costs 0 0 0 0 0 0
Operating income 0 480 600 750 1,200 1,800
 SP VC PU CMPU
Option 1 Rs. 200 – Rs.120 = Rs.80
Option 2 Rs.200 – Rs.150 = Rs.50
Option 3 Rs.200 – Rs.170 = Rs.30
Option 1 has highest CM per unit, because of its low VC per
unit
Once FC are fully recovered at sale of 25 units, each
additional unit sold adds Rs.80 of CM and, therefore,
Rs.80 of OI per unit
The risk-return tradeoff across alternative cost structures
can be measured as operating leverage
Operating leverage describes the effects that FC have on
changes in operating income

Degree of operating leverage = CM / OI

Degree of operating leverage at sales of 40 units for three
rental options
Op 1 Op 2 Op 3
CM PU 80 50 30
CM 3,200 2,000 1,200
OI 1,200 1,200 1,200
Degree of operating leverage
3,200 / 1,200 2,000 / 1,200 1,200 / 12,00
2.67 1.67 1.00
DOL is specific to a given level of sales as a starting point. If
the starting point changes, DOL changes.
For examples for a sale of 50 units, for option 1
DOL = CM 4,000 / OI 2,000 = 2.00
Effect of time horizon
In CVP analysis we assume that costs are either variable or fixed
But whether a cost is variable or fixed depends on the time period for
a decision
The shorter the time horizon, the higher the % of total costs
considered as fixed
Suppose an Indian Airlines plane will depart from its gate in the next
60 minutes and currently has 20 seats unsold
A potential passenger arrives from a competing airline company.
What are the VC to IA of placing one more passenger in an otherwise
empty seat?
VC (such as one more meal) would be negligible
Virtually all costs in this decision situation are fixed, such as baggage
handling costs, crew costs and corporate office costs
Effect of time horizon
Alternatively, suppose IA wants to decide whether to include one
more city in its routes
This decision may have a one year planning horizon
Many more costs, including crew costs, baggage handling costs and air
port fees, would be regarded as variable, and fewer costs would be
regarded as fixed costs in this decision, such as corporate office
costs
This example shows that whether a cost is fixed depends heavily on
the relevant range, the length of time horizon being considered,
and the specific decision situation
Effect of sales mix
Mamta is now budgeting for next convention. She plans to sell two
different software products- Do-All and Superword

Do-All Superword Do-All Superword Total

Units sold 60 40 100
Revenues Rs.200 PU Rs.100 PU Rs. 12,000 Rs. 4,000 Rs. 16,000
VC Rs.120 PU Rs.70 PU 7,200 2,800 10,000
CM Rs.80 PU Rs.30 PU 4,800 1,200 6,000
Fixed costs 4,500
Operating Income 1,500
Multiple Cost Drivers
Mamta is selling only one package, i.e. Do-All
In addition of purchase cost, she also incurs Rs.10 per customer
document preparation cost.

Revenue Rs.200 * units sold

Less: Variable costs
Rs.120 * units sold
Rs.10 * no. of customers
CM
Less: fixed costs Rs.2,000
OI
Multiple Cost Drivers
If Mamta sold 40 packages to 25 custoemrs
OI = 40 * 200 – 40 * 120 – 25 * 10 – 2,000
= 8,000 – 4,800 – 250 – 2,000
= Rs.950

If Mamta sold 40 packages to 40 custoemrs

OI = 40 * 200 – 40 * 120 – 40 * 10 – 2,000
= 8,000 – 4,800 – 400 – 2,000
= Rs.800

There is no unique BEP, when there are multiple cost drivers

Mamta will break even if she sells 26 packages to 8 customers or 27
packages to 16 customers
• B. Obama is a newly elected leader of the Democratic Party. His attitude
has left many an opponent on talk shows feeling run over by a Mack truck.
• Media Publishers is negotiating to publish Obama’s Manifesto, a new book
that promises to be instant best seller. The fixed cost of producing and
marketing the book will be $500,000. The variable costs of producing and
marketing will be $4.00 per copy sold. These costs are before any payment
to Obama. Obama negotiates an upfront payment of $3million, plus a 15%
royalty rate on the net sales price of each book. The net sales price is the
listed book price of $30, minus the margin paid to the bookstore to sell the
book. The normal bookstore margin of 30% of the listed bookstore price is
expected to apply.
• How many copies must Media Publishers sell to (a) break even and (b)
earn a target operating income of $2 million?
• Examine the sensitivity analysis of the BEP to the following changes:
• 1.Decreasing the normal bookstore margin to 20% of the listed bookstore
price of $30.
• 2.Increasing the listed bookstore price to $40 while keeping the margin at
30%.