Cost Accounting

WEEK NINE
COST-VOLUME-PROFIT RELATIONSHIPS
REFERENCES:
MANAGERIAL ACCOUNTING, MCGRAW HILL
INTERNATIONAL EDITION, 11TH EDITION
GARRISON / NOREEN / BREWER

Learning Objectives
2

1.
2.
3.

4.
5.
6.

Explain how changes in activity affect contribution margin

and net operating income.
Prepare and interpret a cost-volume-profit (CVP) graph.
Use the contribution margin ratio (CM ratio) to compute
changes in contribution margin and net operating income
resulting from changes in sales volume.
Show the effects on contribution margin of changes in variable
costs, fixed costs, selling price, and volume.
Compute break-even point in unit sales and sales dollars.
Determine the level of sales needed to achieve a desired target
profit.

Prepared by: Deva Djohan, BCom

Introduction
3

Cost-Volume-Profit Analysis is one of the most

powerful tools that managers have at their command.
It is a vital tool in many business decisions i.e.

What products and services to offer.

What pricing policy to follow.
What marketing strategy to employ.
What basic cost structure to use.

Prepared by: Deva Djohan, BCom

Introduction
4

Cost-Volume-Profit Analysis also helps

managers understand the relationship among cost, volume,
and profit by focusing on interactions among the following
five elements:

Price of products
Volume or level of activity
Per unit variable costs
Total fixed costs
Mix of products sold

Prepared by: Deva Djohan, BCom

The Basics of CVP Analysis

5

The contribution income statement emphasizes the behavior

of costs and therefore is extremely helpful to a manager in
judging the impact on profits of changes in selling price,
cost, or volume.

Prepared by: Deva Djohan, BCom

Contribution Income Statement

ACOUSTIC CONCEPTS, INC.
Contribution Income Statement
For the Month of June
Total

Per Unit

Sales (400 speakers)

$100.000

$250

Less variable expenses

($60.000)

$150

Contribution margin

$40.000

$100

Less fixed expenses

$35.000

Net operating income

$5.000

Prepared by: Deva Djohan, BCom

Contribution Margin
7

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 enough goods are sold to generate sufficient contribution
margin, then all of the fixed expenses will be covered and
the company will break even for the month that is, it will
show neither profit nor loss but just cover its costs.

Prepared by: Deva Djohan, BCom

CVP Relationships in Graphic Form

8

The relationships among revenue, cost, profit, and volume

can be expressed graphically by preparing a cost-volumeprofit (CVP) graph.
A CVP graph highlights CVP relationships over wide ranges of
activity and can give managers a perspective that can be
obtained in no other way.

Prepared by: Deva Djohan, BCom

Preparing the CVP Graph

9

In CVP graph (sometimes called a break-even chart), unit

volume is commonly represented on the horizontal (X) axis
and dollars on the vertical (Y) axis.

Prepared by: Deva Djohan, BCom

Preparing the CVP Graph

10

Three steps in preparing CVP graph:

1.
2.

3.

Draw a parallel line to the volume axis to represent total

fixed expense.
Choose some volume of unit sales and plot the point
representing total expenses (fixed and variable) at the
activity that you have selected.
Again choose some volume of units sales and plot the
point representing total sales dollars at the activity level
you have selected.

Prepared by: Deva Djohan, BCom

CVP Graph

Dollar
Amount

11

Prepared by: Deva Djohan, BCom

Volume of speakers
sold

Contribution Margin Ratio (CM Ratio)

12

In this section, we show how the contribution margin ratio

can be used in cost-volume-profit calculations.
The contribution margin as a percentage of sales is referred
as the contribution margin ratio (CM ratio). This
ratio is computed as follow:
CM ratio = Contribution margin
Sales

Prepared by: Deva Djohan, BCom

Contribution Margin Ratio (CM Ratio)

ACOUSTIC CONCEPTS, INC.
Contribution Income Statement
For the Month of June
Total

Per Unit

Percent of Sales

Sales (400 speakers)

$100.000

$250

100%

Less variable expenses

($60.000)

$150

60%

Contribution margin

$40.000

$100

40%

Less fixed expenses

$35.000

Net operating income

$5.000

Prepared by: Deva Djohan, BCom

13

Contribution Margin Ratio (CM Ratio)

14

The CM ratio is extremely useful since it shows how the

contribution margin will be affected by a change in total
sales.
To illustrate, notice that Acoustic Concepts has a CM ratio of
40%. This means that for each dollar increase in sales, total
contribution margin will increase by 40 cents ($1 sales x
CM ratio of 40%). Net operating income will also increase
by 40%, assuming that fixed costs do not change.

Prepared by: Deva Djohan, BCom

Some Applications of CVP Concepts

The following illustrations

are to show how the CVP
concepts can be used in
planning and decision
making.
Recall the following is the
basic data for Acoustic
Concepts.

ACOUSTIC CONCEPTS, INC.

Contribution Income Statement
For the Month of June
Per Unit

Percent of
Sales

Sales (400 speakers)

$250

100%

Less variable expenses

$150

60%

Contribution margin

$100

40%

Prepared by: Deva Djohan, BCom

15

Changes in Fixed Costs and Sales Volume

16

Acoustic Concepts is currently selling 400 speakers per

month (monthly sales of $100,000). The sales manager
feels that a $10,000 increase in the monthly advertising
budget would increase monthly sales by $30,000 to a total
of 520 units.
Should the advertising budget be increased?

Prepared by: Deva Djohan, BCom

Changes in Fixed Costs and Sales Volume

Incremental contribution margin:

$30,000 x 40% CM ratio

$12,000

Less incremental advertising expense

$10,000

Increased net operating income

$2,000

Prepared by: Deva Djohan, BCom

17

Changes in Variable Costs and Sales Volume

18

Management is considering the use of higher-quality

components, which would increase variable costs (and
thereby reduce the contribution margin) by $10 per
speaker.
However, the sales manager predicts that the higher overall
quality would increase the sales to 480 speaker per month.
Should the higher-quality components be used?

Prepared by: Deva Djohan, BCom

Changes in Variable Costs and Sales Volume

Expected total contribution margin with higher quality components:

480 speakers x $90 per speaker

$43,200

Present total contribution margin

400 speakers x $100 per speaker
Increase in total contribution margin

Prepared by: Deva Djohan, BCom

$40,000
$3,200

19

Changes in Fixed Costs, Sales Price & Sales Volume

20

To increase sales, the sales manager would like to cut the

selling price by $20 per speaker and increase the
advertising budget by $15,000 per month.
The sales manager believes that if these two steps are taken,
unit sales will increase by 50% to 600 speakers per month.
Should the changes be made?

Prepared by: Deva Djohan, BCom

Changes in Fixed Costs, Sales Price & Sales Volume

Expected total contribution margin with lower selling price:

600 speakers x $80 per speaker

$48,000

Present total contribution margin

400 speakers x $100 per speaker

$40,000

Incremental contribution margin

$8,000

Changes in fixed expenses:

Less incremental advertising expense
Reduction in net operating income
Prepared by: Deva Djohan, BCom

$15,000
($7,000)

21

Break-Even Analysis
22

CVP analysis is sometimes referred to simply as break-even

analysis. This is unfortunate because break-even analysis is
only one element of CVP analysis although an important
element.
Break-even analysis is designed to answer questions such as,
how far could sales drop before the company begins to lose
money?

Prepared by: Deva Djohan, BCom

Break-Even Computations
23

Break-even is defined as the level of sales at which the

companys profit is zero.
The break-even point can be computed using either the
equation method or the contribution margin method the
two methods are equivalent.

Prepared by: Deva Djohan, BCom

The Equation Method

24

Profits = (Sales Variable expenses) Fixed expenses

Rearranging:
Sales = Variable expenses + Fixed expenses + Profits
$250Q = $150Q + $35,000 + $0
$250Q - $150Q = $35,000
$100Q = $35,000
Q = $35,000 / 100
Q = 350 speakers

Prepared by: Deva Djohan, BCom

The Equation Method

25

The break-even in total sales dollar, X, can also be computed

as follows:
Sales = Variable expenses + Fixed expenses + Profits
X = 0.60X + $35,000 + $0
X 0.60X = $35,000
0.40X = $35,000
X = $35,000 / 0.40
X = $87,500

Prepared by: Deva Djohan, BCom

The Contribution Margin Method

26

A shortcut version of the equation method.

The approach centers on the idea discussed earlier that

each unit sold provides a certain amount of contribution

margin that goes toward covering fixed costs.

Prepared by: Deva Djohan, BCom

The Contribution Margin Method

27

Break-even point in units sold

=
Fixed expenses
Unit contribution margin
Break-even point in total sales dollars
= Fixed expenses
CM Ratio

Prepared by: Deva Djohan, BCom

Target Profit Analysis

28

CVP formulas can be used to determine the sales volume

needed to achieve a target profit.
Suppose Acoustic Concepts would like to earn a target profit
of $40,000 per month. How many speakers would have to
be sold?

Prepared by: Deva Djohan, BCom

The CVP Equation

29

Sales = Variable expenses + Fixed expenses + Profits

$250Q = $150 Q + $35,000 + $40,000
$100Q = $75,000
Q = $75,000 / 100
Q = 750 speakers
Thus, the target profit can be achieved by selling 750 speakers per
month, which represents $187,500 in total sales ($250 per
speaker x 750 speakers).

Prepared by: Deva Djohan, BCom

The Contribution Margin Approach

30

Units sales to attain the target profit

= Fixed expenses + Target profit
Unit contribution margin
Dollar sales to attain target profit
= Fixed expenses + Target profit
CM Ratio

Prepared by: Deva Djohan, BCom