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CHAPTER ONE

COST-VOLUME-PROFIT (CVP) ANALYSIS

1.1 INTRODUCTION
Cost-volume-profit (CVP) analysis is a powerful tool that helps managers to understand the relationships
among cost, volume, and profit. CVP analysis focuses on how profits are affected by the following five
factors:
1) Selling prices.
2) Sales volume.
3) Unit variable costs.
4) Total fixed costs.
5) Mix of products sold.
1.2 CVP – UNDERLYING ASSUMPTIONS
Cost-Volume-Profit Assumptions and Terminology
1) Changes in the level of revenues and costs arise only because of changes in the number of product
(or service) units produced and sold.
2) Total costs can be divided into a fixed cost and variable cost.
3) When graphed, the behavior of total revenues and total costs is linear (straight-line) in relation to
output units within the relevant range (and time period).
4) The unit selling price, unit variable costs, and fixed costs are known and constant.
5) The analysis either covers a single product or assumes that the sales mix when multiple products
are sold will remain constant as the level of total units sold changes.
6) All revenues and costs can be added and compared without taking into account the time value of
money.
1.3 THE BASICS OF COST-VOLUME-PROFIT (CVP) ANALYSIS
1.3.1 Contribution Margin Vs Gross Margin Concept

The contribution income statement emphasizes the behavior of costs and therefore is extremely helpful to
managers in judging the impact on profits of changes in selling price, cost, or volume.
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, 2006. This income
statement is called contribution approach to income statement.

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Exhibit 1.1
Sample Merchandising Company
Projected Income Statement
For the Month Ended January 31, 2006
Total Per 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

Contribution Margin
 It represents the amount remaining from sales revenue after variable expenses have been deducted
i.e., CM = Sales Revenue – Variable Costs
 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.
Per unit contribution margin
 It 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.

To illustrate with an extreme example, assume that the company sells only 5000 units during a particular
month. The company’s income statement would appear as follows:

Sample Merchandising Company

Projected Income Statement
For the Month Ended January 31, 2006
Total Per Unit
Sales (5, 000 units) Br. 75, 000 Br.15.00
Variable Expenses 60, 000 12.00
Contribution Margin Br. 15, 000 Br.3.00
Fixed Expenses 24, 000
Net Loss Br. (9, 0000)

i.e., 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.

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 breakeven point), the company will have to sell 8, 000 units in a month,
since each unit sold yield Br. 3.00 in contribution margin.

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Sample Merchandising Company
Projected Income Statement
For the Month Ended January 31, 2006
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 Loss 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:
Sample Merchandising Company
Projected Income Statement
For the Month Ended January 31, 2006
Total Per Unit Percentage
Sales (10, 000 units) Br. 150, 000 Br.15.00 100%
Variable Expenses 120, 000 12.00 80%
Contribution Margin Br. 30, 000 Br.3.00 20%
Fixed Expenses 24, 000
Net Income Br. 6, 0000

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.

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At this illustration suggests, the impact on net income of any given birr change in total sales & 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:

Sample Merchandising Company

Projected Income Statement
For the Month Ended January 31, 2006
Total Per Unit
Sales (8, 001 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 Loss Br. 3.00
 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.

1.4 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 total contribution margin equals total fixed
expenses. Stated differently, it is a point where the operating income is zero.
 There are three alternative approaches to determine break-even point:
(A) Equation technique,
(B) Contribution margin technique and
(C) Graphical method.
A) Equation Method
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:

Operating profit = Total Revenue – Total Costs

π=¿ TR – TC, where TR = Average SP/unit (sp) x units of output (Q)
TC = (Variable costs/unit (VC) x units of output (Q))+Fixed costs (FC)

 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

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this unit non-operating revenues and non-operating cost are assumed to be zero. Thus, the above
formula can be restated as follows
π = (SPxQ) – ((VCxQ) +FC) ………… expanding original equation for profits!
π = (SP - VC) Q - FC
 At break-even point, net income=0 because total revenue equal total expenses.
That is, NI=SPQ-VCQ-FC
0= SPQ-VCQ-FC ……………………………………equation (1)
B) 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 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.

 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= SPQ-VCQ-FC
0=Q (SP-VC)-FC ………………………… because at BEP net income equals zero.
Q (SP-VC) =FC …………………………… divide both sides by (p-v)
Q = FC ………………….……………….. Equation (2)
SP-VC
 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.
C) 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, 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.
Example (1) Zoom Company manufactures and sells a telephone answering machine. The company’s
income statement for the most recent year is given below:

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Total Per Unit Percent

Sales (20,000 units) Br. 1,200,000 Br. 60 100
Variable expenses 900,000 45 ?
Contribution Margin Br. 300,000 Br. 15 ?
Fixed Expenses 240,000
Net Income 60,000
Based on the above data, answer the following questions.
Instructions:
a) Compute the company’s CM ratio and variable expense ratio.
b) Compute the company’s break-even point in both units and sales birrs. Use the above three
approaches to compute the break-even.
c) Assume that sales increase by Br. 400,000 next year. If cost behavior patterns remain unchanged,
by how much will the company’s net income increase?
Solution:
a) CM – ratio = 60-45 = 0.25 (25%)
60
Variable expense ratio = 1 – CM-ratio = SP-VC= 1-0.25 = 60 – 15 = 0.75 (75%)
SP 60
b) Method 1: Equation Method
i) Net Income (NI) = SPQ – VCQ – FC
0 = Q (60-45) – 240,000
15Q = 240,000
BEPQ = 240,000 = 16,000 units, at Br. 60 per unit, Br. 960,000 (BEP sales in Birr)
15
ii) Let “X” be sales volume in birrs to breakeven
CM- ratio = 0.25 ; Variable expense ratio = 0.75
Net Income = Total revenue – Total variable expense – total fixed cost
0 = X – 0.75X-240, 000
0.25X = 240,000
X = 240,000 = Br. 960,000
0.25
Method 2: Contribution Margin Method
i) BEP (in units) = Fixed expenses = Br. 240,000 = 16,000 units
CM per unit Br. 60 – Br. 45
ii) BEP (in birrs) = Fixed expenses = Br. 240,000 = Br. 960,000
CM – ratio 0.25
Method 3: Graphical Method: To plot fixed costs, measure Br. 240,000 on the vertical axis and extend a
line horizontally. Select a point (say, 20,000 units) and determine the total costs (the total of fixed and
variable) at the selected activity level. The total costs at this output level are Br. 1,140,000= Br. 240,000 +
(20,000 X Br. 45). Then, starting from the selected point draw a line back to the origin where the fixed
cost line touches the vertical axis. The break-even point (BEP) is where the total revenues line and the
total costs line intersect. At this point, total revenues equal total costs. Refer Exhibit 1.2.
Exhibit 1.2Cost-Volume-Profit Chart

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TR
TC

Sales in birr Profit area

(TR>TC)
Br.1, 500,000

TVCs @ Br. 45 per units

Loss area BEP: 16,000 units or
(TR<TC) Br.960, 000 sales
Br. 750,000

Br. 500,000
TFC @ Br. 240, 000
0 10,000 20,000 30,000 Volume in units sold
c)
Increase in sales Br. 400,000
Multiply by the CM ratio X 25%
Expected increase in contribution margin Br. 100.000

 Since the fixed expenses are not expected to change, net income will increase by the entire Br.
100,000 increase in contribution margin.

1.5 APPLYING CVP ANALYSIS

1.5.1 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 output 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:

Sample Projected Income Statement

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Total Per Unit
Sales (400 speakers) Br. 100, 000 Br.250.00
Variable Expenses 60, 000 150.00
Contribution Margin Br. 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 to show the effects of changes in
variable costs, fixed costs, sales, and sales volume on the company’s profitability.

(i) 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?
Expected contribution margin (Br.130, 000 x 40% CM ratio)………..… Br.52, 000
Present contribution margin (Br.100, 000 x 40% CM ratio)………….… 40, 000
Incremental contribution margin…………………………….……………………… 12, 000
Change in fixed costs (incremental advertising expense)……..…………… 10, 000
Increased net income……………………………………..……………………………….. Br. 2,
000
 Answer is: Yes, based on the information above and assuming that other factors in the company
don’t change, the advertising budget should be increased.

(ii) 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?
The Br10 increase in variable costs will cause the unit contribution margin to decrease from Br.100 to
Br90.
Expected total contribution margin (480 speakers xBr.90)…………… Br.43, 200
Present total contribution margin (400 speakers xBr.100)……………. 40, 000
Increase in total contribution margin…………………………………… Br.3, 200
 Answer is: Yes, based on the information above, the high-quality component should be used. Since
the fixed expenses will not change, net income will increase by the Br3, 200 increase in
contribution margin shown above.

(iii) 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?

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A decrease of Br 20 per speaker in the selling price will cause the unit contribution margin to decrease
from Br100 to Br 80.
Expected total contribution margin :(400-speakersx150%xBr80)………………… Br.80, 000
Present total contribution margin (400 speakers x Br 100)……….………………... 40,000
Incremental contribution margin……………………………………..………………. 8,000
Change in fixed costs:
Incremental advertising expenses………………………………...……………………. 15, 000
Reduction in net income…………………………………………………..…………… Br. (7, 000)
 Answer is: NO, based on the information above, the changes should not be made.

(iv) 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?
Changing the sales staff from a salaried basis to a commission basis will affect both fixed and variable
costs. Fixed costs will decrease by Br 6,000, from Br 35, 000 to Br 29, 000. Variable costs will increase
by Br 15, from Br 150 to Br 165, and the unit contribution margin will decrease from Br 100 to Br 85.
Expected total contribution margin (400speakers x 115% x Br85)………………. Br.39, 100
Present total contribution margin (400 speakers x Br. 100)………….……………… 40, 000
Decrease in total contribution margin………………………………………………….……….. (900)
Change in fixed costs:
Salaries avoided if a commission is paid [to be added on Br. (900)]………………… 6, 000
Increase in net income……………………………………………………………………………………
Br.5, 100
 Answer is: Yes, based on the information above, the changes should be made. Again, the same
answer can be obtained by preparing comparative income statements:
Present 400 Expected 460*
Speakers per month speakers per month
Total Per unit Total Per unit
Sales Br100, 000 Br.250 Br 115, 000 Br 250
Variable costs 60, 000 150 75, 900 165
Contribution margin 40, 000 Br.100 39, 100 Br 85
Fixed expenses 35, 000 29, 000
Net income Br 5, 000 Br 10, 100
*400 speakers x 115%= 460 speakers

(v) Changes in Regular Sales Price:

 Refer the original data. The company has an opportunity to make a 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?
Variable cost per speaker…………………………..…………………. Br 150
Desired profit per speaker (Br3, 000÷150 speakers)……… 20

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Quoted price per speaker…………………………………………..… Br 170
Notice that no element of fixed cost is included in the computation. This is because fixed costs are not
affected by the bulk sale, so all of the additional revenue that is in excess of variable costs goes to
increasing the profits of the company.

1.5.2 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.
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.
Solutions:
a) The BEP using contribution margin technique can be calculated as:
BEP (in birrs) = Fixed Expenses = Br. 180,000 + 72,000 = Br. 630,000
Cost –ratio 0.4
b) Target – net profit analysis can be approached using either of these two methods
i. Equation method
ii. Contribution margin method
i) Equation Method.
 Managers use a targeted income as the starting point in decision which marketing and
pricing strategies to use.
 The formula to determine a specific targeted income is an extension of the break-even
formula. Here, instead of solving sales volume where profits are zero, you instead solve
sales where profit equals some targeted amount. The equation for target income is:

TI = Total sales – Variable expenses – Fixed expenses

TI = SPQ – VCQ – FC
Where SP = sales price
Q = sales unit to achieve the targeted income
VC= unit variable costs
FC = fixed costs
For Tantu Company, the targeted sales volume in units would be determined as given below:
TI = SPQ – VCQ – FC
180, 000 = 20Q – 12Q – 252, 000
8Q= 180, 000 + 252, 000
Thus, Q= Br.432, 000 = 54, 000 units

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8
 Target sales (in birrs) = Br.20 x 54,000=Br. 1, 080, 000
Alternatively computed,
 Target income=SPQ –VCQ – FC = Total CM* - FC = CM-ratio x S – FC where S= Birr sales to
achieve the target income
Target income= 0.4S – Br.252, 000
Br. 180, 000=0.4S- Br.252, 000
= Br.1, 080, 000
ii) Contribution Margin Approach.
 A second approach would be expanding the contribution margin formula to include the target
income requirements. Thus, we can modify the formula given earlier for BEP computations as
follows:

Target sales (in units) = Fixed expenses + Target Profit

Unit CM

 This approach is simpler and more direct than using the CVP equation. In addition, it shows
clearly that once the fixed costs are covered, the unit contribution is fully available for meeting
profit requirements.
Target sales (in units) = Fixed expenses + Target Profit = Br.252, 000+180, 000 =54, 000 units
Unit CM Br. 8

 Target sales in birrs (for Tantu) = Br.20 x 54, 000 = Br.1, 080, 000

 The total birr sales required to earn a target net profit is found by:
Target sales (in birrs) = Fixed expenses + Target Profit
CM-ratio
 Target sales in birrs (for Tantu) = Br.252, 000 + Br. 180, 000 = Br. 1, 080, 000
0.4

1.5.3 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:

Margin of safety = Total sales - Break even Sales

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 %age) = Margin of safety in birrs
Total sales
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Example (1): Consider the cost structure for ABC Company and XYZ in Exhibit 1-3
ABC Co. and XYZ Co.
Comparative Cost Structures
ABC Co. XYZ Co.
Amount Percent Amount Percent
Sales Br. 500,000 100 Br. 500,000 100
Variable costs 100,000 20 300,000 60
Contribution Margin 400,000 80 200,000 40
Fixed costs 300,000 100,000
Net income Br. 100,000 Br. 100,000
The break even sales for each company may be computed as follows:
 BEP (in birrs) = Fixed Costs
CM ratio
 BEP (ABC Co.) = Br.300, 000 = Br.375, 000
0.8
 BEP (XYZ Co.) = Br.100, 000 = Br.250, 000
0.4

The margin of safety for each company may be computed as:

 Total sales - Break even Sales = Margin of safety
 ABC Co.’s: Br.500, 000- Br.375, 000 = Br.125, 000
 XYZ Co.’s: Br.500, 000- 250,000 = Br. 250,000

 Note that the companies’ sales revenues are the same (Br. 500,000) and their net incomes are the
same (Br. 100,000) their individual margins of safety are different.
 This is because they have different cost structures, and consequently different breakeven.
 A higher breakeven sales amount for ABC Co. produces a lower margin of safety.
For ABC Co., the Br.125, 000 margin of safety means that sales would have to diminish
by more than this amount before the company suffers a loss. In effect the margin of safety
is a buffer before losses are incurred.
The same analysis applies to XYZ Co., except its buffer is Br. 250,000. At this point,
neither company is experiencing losses;
 Thus it is difficult to say which company is better off. Because they are in different businesses the
amounts computed as buffers may mean the companies’ operating results are fine. A comparison
within each company on a year-by-year basis may shed light on the possibility of impending
difficulties.
The margin of safety may also be expressed as a percentage. The calculation is done by dividing the
margin of safety (in birrs) by the total sales (in birrs). This, the calculation of the margins of safety
percentage is:

Margin of safety percentage = Margin of safety in birrs

Total sales in birrs
ABC Co.’s: Br. 125,000 = 25 %
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XYZ Co.’s: Br. 250,000 = 50 %
Br.500, 000
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1.6 CVP CONSIDERATIONS IN CHOOSING A COST STRUCTURE

Cost structure refers to the relative proportion of fixed and variable costs in an organization. Managers
often have some latitude in trading off between these two types of costs. For example, fixed investments
in automated equipment can reduce variable labor costs. In this section, we discuss the choice of a cost
structure. We introduce the concept of operating leverage, which plays a key role in determining the
impact of cost structure on profit stability.

1.6.1 Cost Structure and Profit Stability

Which cost structure is better — high variable cost and low fixed costs, or the opposite? No single answer
to this question is possible; each approach has its advantages. To show what we mean, refer to the income
statements given below for two farms.
Example (1) Revenue and cost behavior relationships at two firms, A and B, follows:
Firm A Firm B
Amount Percent Amount Percent
Sales …………………………………….… Br.100, 000 100 Br.100, 000 100
Less variable expenses ……………. 60,000 60 30,000 30
Contribution margin ……………..… 40,000 40 70,000 70
Less fixed expenses ………………… 30,000 60,000
Net income ……………………………. Br. 10,000 Br. 10,000

 Firm A has higher variable costs because it is labor-intensive while Firm B has higher fixed costs
as a result of its investment in machines.
 The question as to which firm has the better cost structure depends on many factors, including the
long run trend in sales, year-to-year fluctuations in the level of sales and the attitude of the owners
toward risk.
 If sales are expected to trend above Br. 100, 000 in the future, then Firm B has the better-cost
structure. The reason is that its CM ratio is higher, and its profits will therefore increase more
rapidly as sales increase.
To illustrate, assume that each firm experiences a 10% increase in sales. The new income statement will
be as follows:

Firm A Firm B
Amount Percent Amount Percent
Sales …………………… Br.110, 000 100 Br.110, 000 100
Less variable expenses …. 66,000 60 33,000 30
Contribution margin …… 44,000 40 77,000 70
Less fixed expenses …… 30,000 60,000

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Net income ……………. Br. 14,000 Br. 17,000
 As we would expect, for the same birr increase in sales, Firm B has experienced a greater increase
in net income due to its higher CM ratio.
What if sales can be expected to drop below Br.100, 000 from time to time? What are the break-even
points of the two firms? What are their margins of safety? The computations needed to answer these
questions are carried out below using the contribution margin method.
Firm A Firm B
Fixed expenses ……………………………….. Br.30, 000 Br.60, 000
Contribution margin ratio ……………… ¸ 40% ¸70%
Breakeven in total sales birrs. ……… Br.75, 000 Br.85, 714
Total current sales (a) ………………………… Br.100, 000Br.100, 000
Break-even sales ………………………………. 75,000 85,714
Margin of safety in sales birrs (b) ……… Br. 25,000 Br. 14,286
Margin of safety as a %age of sales (b) ¸ (a) 25.0% 14.3%
 This analysis makes it clear that Firm A is less vulnerable to downturns than Firm B.
 We can identify two reasons why it is less vulnerable.
 First, due to its lower fixed expenses, Firm A has a lower break-even point and a higher
margin of safety, as shown by the computations above. Therefore, it will not incur losses as
quickly as Firm B in periods of sharply declining sales.
 Second, due to its lower CM ratio, Firm A will not lose contribution margin as rapidly as
Firm B when sales fall off. Thus, Firm A’s income will be less volatile. We saw earlier that
this is a drawback when sales increase, but it provides more protection when sales drop.
 To summarize, without knowing the future, it is not obvious which cost structure is better. Both
have advantages and disadvantages. Firm B, with its higher fixed costs and lower variable costs,
will experience wider swing in net income as changes take place in sales, with greater profits in
good years and greater losses in bad years. Firm A, with its lower fixed costs and higher variable
costs, will enjoy greater stability in net income and will be more protected from losses during bad
years, but at the cost of lower net income in good years.

1.6.2 Operating Leverage

To the scientist, leverage explains how one is able to move a large object with a small force. To the
manager, leverage explains how one is able to achieve a large increase in profits with only a small
increase in sales and/or assets. One type of leverage that the manager uses to do this is known as operating
leverage.
Operating leverage –is a measure of how sensitive net operating income is to a given percentage change
in dollar sales. Operating leverage acts as a multiplier. If operating leverage is high, a small percentage
increase in sales can produce a much larger percentage increase in net operating income.

Operating leverage
 It is a measure of the extent to which fixed costs are being used in an organization.
 It is greatest in companies that have a high proportion of fixed cost in relation to variable costs.
 Conversely, operating leverage is lowest in companies that have a low proportion of fixed costs in
relation to variable costs. I

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 f a company has high operating leverage (that is, a high proportion of fixed costs in relation to
variable costs), then profits will be very sensitive to changes in sales. Just a small percentage
increase (or decrease) in sales can yield a large percentage increase (or decrease) in profits.
Operating leverage can be illustrated by returning to the data given above for the two firms, A and B. Firm
B has a higher proportion of fixed costs in relation to its variable costs than does Firm A, although total
costs are the same in the two firms at a $100,000 sales level. We previously showed that with a 10%
increase in sales (from $100,000 to $ 110,000 in each firm), the net income of Firm B increases by 70%
(from $10,000 to $17,000), whereas the net income of Firm A increases by only 40% (from $10,000 to
$14,000). Thus, for a 10% increase in sales, Firm B experiences a much greater percentage increase in
profits than does Firm A. The reason is that Firm B has greater operating leverage as a result of the greater
amount of fixed cost in its cost structure.
The DOL at a given level of sales is computed by the following formula:
Degree of operating leverage (DOL) = Contribution margin
Net income
The degree of operating leverage is a measure, at a given level of sales, of how a percentage change in
sales volume will affect profits. To illustrate, the degree of operating leverage for the two firms at a Br.
100, 000 sales would be as follows:
Firm A: Br.40, 000 = 4 Firm B: Br.70, 000 =7
Br.10, 000 Br.10, 000
 These figures tell us that for a given percentage change in sales we can expect a change four times
as great in the net income of Firm A and a change seven times as great in the net income of Firm
B.
 Thus, if sales increase by 10% then we can expect the net income of Firm A to increase by four
times this amount, or by 40%, and the net income of Firm B to increase by seven times this
amount, or by 70%.
The degree of operating leverage is greater at sales levels near the break-even point and decreases as sales
and profits rise. This can be seen from the tabulation below, which shows the degree of operating leverage
for Firm A at various sales levels. [Data used earlier for Firm A are shown under column (3)]
Sales ……… Br.75, 000 Br.80, 000 Br.100, 000 Br.150, 000 Br.225, 000
Less: VCs 45, 000 48, 000 60, 000 90, 000 135, 000
Contribution margin (a) 30, 000 32, 000 40, 000 60, 000 90, 000
Less fixed expenses … 30,000 30, 000 30, 000 30, 000 30, 000
Net income (b) … Br. –0- Br.2, 000 Br. 10, 000 Br.30, 000 Br.60, 000
DOL (a)÷(b) ∞ 16 4 2 1.5

Thus, a 10% increase in sales would increase profits by only 15%(10% x 1.5) if the company were
operating at a Br. 225, 000 sales level, as computed to the 40% increase we computed earlier at the
Br.100, 000 sales level. The degree of operating leverage will continue to decrease the farther the
company moves from its break-even point. At the break-even point, the degree of operating leverage will
be infinitely large (Br.30, 000 contribution margin÷Br.0 net income=∞)

A manager can use the degree of operating leverage to quickly estimate what impact various percentage
changes in sales will have on profits, without the necessity of preparing detailed income statements. As
shown by our examples, the effect of operating leverage can be dramatic. If a company is fairly near its
break-even point, then even small increase in sales can yield large increase in profits. This explains why

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management often works very hard for only a small increase in sales volume. If the degree of operating
leverage is 5, then a 6% increase in sales would translate into a 30% increase in profits.

1.7 CVP ANALYSIS WITH MULTIPLE PRODUCTS

1.7.1 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.
1.7.2 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:

SP1Q1 + SP2Q2+...+PnQn – VC1Q1 – VC2Q2-...VnQn – FC =

NI
Using contribution margin approach, the computation of the break-even point (BEP) in multi product firm
follows:
BEP (in units) = Total fixed expenses BEP (in birrs) = Total Fixed Expenses
Weighted average CM CM – ratio

Exhibit 1–3: Multiproduct Break-Even Analysis

ABC Co. and XYZ Co.
Comparative Cost Structures
Product “X” Product “Y” Total
Amount % Amount % Amount %
Sales Br. 20,000 100 Br. 80,000 100 100,000 100
Variable costs 15,000 75 40,000 50 55,000 55
C.M Br.5,000 25 Br.40,000 50 45,000 45
Fixed Costs ……………………………………………… 27,000
…………………
Net Income ……………………………………………… Br. 18,000
…………………

Computation of BEP: Fixed costs = Br. 27,000 = Br. 60,000

Overall CM ratio 0.45
Verification of the BEP:
Product “X” Product “Y” Total
Current Birr sales ……………… Br. 20,000 Br. 80,000 Br. 100,000
Percentage of total Birr sales 20% 80% 100%

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Sales at BEP Br. 12,000 Br. 48,0000 Br. 60,000

Product “X” Product “Y” Total

Amount % Amount % Amount %
Sales Br. 12,000 100 Br. 48,000 100 Br. 60,000 100
Variable costs 9,000 75 24,000 50 33,000 55
C.M Br. 3,000 25 Br. 24,000 50 27,000 45
Fixed Costs ……………………………………………… 27,000
…………………
Net Income ……………………………………………… Br. 0
…………………

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