Chapter 07 – Cost-Volume-Profit Analysis
7-1
CHAPTER 7
COST-VOLUME-PROFIT ANALYSIS
Learning Objectives
1. Compute a break-even point using the contribution-margin approach and the
equation approach.
2. Compute the contribution-margin ratio and use it to find the break-even point in
sales dollars.
4. Apply CVP analysis to determine the effect on profit of changes in fixed
expenses, variable expenses, sales prices, and sales volume.
5. Compute the break-even point and prepare a profit-volume graph for a
multiproduct enterprise.
6. List and discuss the key assumptions of CVP analysis.
8. Explain the role of cost structure and operating leverage in CVP relationships.
10. Be aware of the effects of advanced manufacturing technology on CVP
relationships.
Chapter 07 – Cost-Volume-Profit Analysis
7-2
Chapter Overview
I. Illustration of Cost-Volume-Profit (CVP) Analysis
A. Importance of cost behavior
II. The Break-even Point
A. Contribution-margin approach
B. Contribution-margin ratio
C. Equation approach
III. Graphing CVP relationships
A. Interpreting the CVP graph
B Profit-volume graph
IV. Target Profit
A. Contribution-margin approach
B. Equation approach
C. Graphical approach
V. Applying CVP Analysis
A. Safety margin
B. Changes in fixed expenses
C. Changes in unit contribution margin
D Predicting profit given expected volume
E. Interdependent changes in key variables
VI. CVP Analysis with Multiple Products
A. Sales mix
VII. Assumptions Underlying CVP Analysis
VIII. CVP Relationships and the Income Statement
A. Traditional income statements
B. Contribution income statements
IX. Cost Structure and Operating Leverage
X. CVP Analysis, Activity-Based Costing, and Advanced Manufacturing Systems
A. A move towards JIT and flexible manufacturing
XI. Appendix: Effect of Income Taxes
Chapter 07 – Cost-Volume-Profit Analysis
7-3
Key Lecture Concepts
I. Illustration of Cost-Volume-Profit (CVP) Analysis
• CVP analysis, often referred to as break-even analysis, examines the
interrelationship of sales activity, prices, costs, and profits in planning and
decision-making situations.
II. The Break-even Point
• The break-even point is the point where revenues and expenses are equal.
• There are two approaches to calculating the break-even point for a firm:
the contribution-margin approach and the equation approach.
➢ The contribution-margin approach is based on the concept of the
contribution margin, or the amount that each unit contributes
toward covering fixed expenses and generating profit.
▪ Contribution margin = Selling price – Variable expenses per
unit
▪ To find the break-even point in dollars, simply multiply the
break-even point in units by the selling price.
▪ Alternatively, one can use the contribution margin ratio,
which is the contribution margin expressed as a percentage
of the selling price. Thus:
➢ The equation approach is based on the net income equation that
students already know: Sales – Total variable expenses – Total
Chapter 07 – Cost-Volume-Profit Analysis
7-4
fixed expenses = Profit.
III. Graphing CVP relationships
• CVP relationships can be communicated in the form of a cost-volume-
profit graph, which shows the effects on profit of a change in volume (see
Exhibit 7-1 in the text).
IV. Target Profit
• The preceding equations can be modified to determine the level of sales
needed to produce a particular target net profit.
➢ Contribution approach—Each unit now contributes toward covering
fixed expenses and generating profit (some amount other than
zero). Accordingly, the equation becomes:
➢ Equation approach—Sales dollars must now be large enough to cover
variable expenses and fixed expenses, and produce a particular
profit. Thus:
V. Applying CVP Analysis
• The safety margin, which shows the amount that sales can fall before a
firm starts losing money, is computed as follows:
Safety margin = Budgeted sales – Break-even sales
Chapter 07 – Cost-Volume-Profit Analysis
7-5
VI. CVP Analysis with Multiple Products
• Most organizations have more than one product line, and CVP analysis
may be adapted for these firms. The same basic equations are used;
however, the contribution margin must be weighted by the sales mix.
• A weighted-average unit contribution margin is calculated by
multiplying a product’s contribution margin by its sales mix percentage,
and then summing the results for individual products.
• As a final step, the sales-mix percentages are multiplied by the number of
“units” to calculate individual product sales to break even.
VII. Assumptions Underlying CVP Analysis
• The CVP model is based on a number of underlying assumptions, as
follows:
➢ The behavior of total revenue is linear within the relevant range.
Chapter 07 – Cost-Volume-Profit Analysis
7-6
➢ Inventory levels at the beginning and end of the accounting period
are the same. This assumption implies that during the period, the
number of units sold equals the number of units produced.
VIII. CVP Relationships and the Income Statement
• The traditional income statement for a manufacturer includes a cost-of–
goods-sold figure that combines variable costs and fixed manufacturing
overhead. The gross margin is equal to sales minus cost of goods sold.
The statement’s format does not group costs by behavior but rather by
function, thus making CVP analysis difficult.
• The contribution income statement is presented in a format that
highlights cost behavior.
➢ Variable expenses are subtracted from sales to produce a total
contribution margin.
IX. Cost Structure and Operating Leverage
• The cost structure of an organization is the relative proportion of fixed
and variable costs. An automated manufacturing plant has a high
proportion of fixed costs while a labor-intensive plant has a high
proportion of variable costs.
Chapter 07 – Cost-Volume-Profit Analysis
7-7
• A firm’s cost structure has a significant effect on the way that profits
fluctuate in response to changes in sales volume. The greater the
proportion of fixed costs, the greater the impact on profit from a given
percentage change in sales revenue.
• The extent to which an organization uses fixed costs in its cost structure is
called operating leverage.
➢ A company with a high proportion of fixed costs and a low
proportion of variable costs has high operating leverage and the
ability to greatly increase net income from an increase in sales
revenue.
➢ The degree of operating leverage can be measured as follows:
Operating leverage factor = Contribution margin ÷ Net
income
X. CVP Analysis, Activity-Based Costing, and Advanced Manufacturing Systems
• Cost behavior may change with a shift from a traditional-costing system
to an ABC system.
➢ The traditional CVP analysis recognizes a single, volume-based
cost driver, namely, sales volume. With the multiple drivers of
• With the improved accuracy of ABC, a company receives a richer
Chapter 07 – Cost-Volume-Profit Analysis
7-8
understanding of cost behavior and CVP relationships.
XI. Appendix: Effect of Income Taxes
• The target net profit figure discussed in the body of the chapter is stated in
terms of before-tax income. The appendix focuses on a target, after-tax
figure.
Chapter 07 – Cost-Volume-Profit Analysis
7-9
Teaching Overview
Students are particularly interested in CVP analysis, often because they help plan
campus events where being able to predict the break-even point or calculate an
appropriate ticket price is helpful.
Based on many years’ teaching experience, I offer the following words of wisdom: First,
spend a little extra time on CVP and the sales mix, showing how to weight the unit
contribution margins and explaining the conceptual basis for doing so. Students have
some difficulty in understanding why the weighting is necessary rather than just using
Chapter 07 – Cost-Volume-Profit Analysis
7-10
Links to the Text
Homework Grid – CHAPTER 7
Item No.
Learning
Objectives
Completion
Time (min.)
Special
Features*
Exercises:
7-23
1, 2, 4
20
7-24
1
25
7-25
3, 4
25
7-26
3, 4
25
7-27
1, 4
25
I
7-28
7, 8
25
7-29
4
30
C
7-30
1, 5
30
7-31
8
25
7-32
7
10
7-33
1, 4, 11
20
Problems:
7-34
1, 2, 4
30
7-35
1, 2, 4
30
7-36
1, 2, 4
30
7-37
1, 4
30
7-38
1, 4
25
7-39
4, 5, 7
40
7-40
1, 4
35
I
7-41
1, 3, 4
45
7-42
3, 4, 8
40
7-43
4, 8
35
7-44
1, 8, 10
45
W
7-45
1, 4
40
7-46
1, 4
35
7-47
1, 4, 9, 10
40
E, W
7-48
1, 4, 10
45
I
7-49
4, 5
45
S
7-50
1, 2, 3, 4, 11
35
I
7-51
1, 2, 4, 5, 11
35
7-52
1, 4, 11
45
7-53
1, 4, 11
45
Chapter 07 – Cost-Volume-Profit Analysis
7-11
Item No.
Learning
Objectives
Completion
Time (min.)
Special
Features*
Cases:
7-54
1, 4
50
G, S
7-55
1, 2, 4, 11
50