Copyright © 2003 Pearson Education Canada Inc. Slide 3-28
Chapter 3
Cost-Volume-Profit Analysis

Copyright © 2003 Pearson Education Canada Inc. Slide 3-29
Cost-Volume-Profit Analysis
• Examines the behaviour of total revenues, total costs,
and operating income as changes occur in the output
level, selling price, variable costs or fixed costs
Assumptions of CVP Analysis
1. revenues change in relation to production and sales
2. costs can be divided in variable and fixed categories
3. revenues and costs behave in a linear fashion
4. costs and prices are known
5. if more than one product exists, the sales mix is
constant
6. we can ignore the time value of money
Page 67

Copyright © 2003 Pearson Education Canada Inc. Slide 3-30
Contribution Margin
• Contribution margin is equal to the difference
between total revenue and total variable costs
Contribution margin per unit
= Selling price - Variable cost per unit
Contribution margin percentage
= Contribution margin per unit / selling price per unit
Pages 68 - 69
Revenue $200 $400 100%
Variable costs 120 240 60%
Contribution margin $80 $160 40%
Total for
Per Unit 2 units %

Copyright © 2003 Pearson Education Canada Inc. Slide 3-31
Contribution Margin Income Statement
Packages Sold
0 1 2 25 40
Revenue $0 $200 $400 $5,000 $8,000
Variable costs 0 120 240 3,000 4,800
Contribution margin 0 80 160 2,000 3,200
Fixed costs 2,000 2,000 2,000 2,000 2,000
Operating income $(2,000) $(1,920) $(1,840) $0 $1,200
• Income statement that groups line items by cost
behaviour to highlight the contribution margin
Page 69

Copyright © 2003 Pearson Education Canada Inc. Slide 3-32
Breakeven Point
• Quantity of output where total revenues equal total
costs
• Point where operating income equals zero
Breakeven point in units
= Fixed costs / Contribution margin per unit
= $2,000 / $80
= 25 units
Breakeven point in dollars
= Fixed costs / contribution margin %
= $2,000 / 40%
= $5,000
Page 71

Copyright © 2003 Pearson Education Canada Inc. Slide 3-33
Cost-Volume-Profit Graph
$10,000
$8,000
$6,000
$4,000
$2,000
$0
0 10 20 30 40 50
Units Sold
Total revenues
line
Breakeven
Point
25 units
Operating
income
Operating
loss
Page 72
Total costs
line

Copyright © 2003 Pearson Education Canada Inc. Slide 3-34
Target Operating Income
• For most firms in the private sector, the main
objective is not to breakeven
• Convert after-tax desired net income to its before-tax
equivalent operating income
Target operating income
= Target net income / (1 - tax rate)
Target Unit Sales
= (Fixed costs + Target operating income)
/ Contribution margin per unit
Target Dollar Sales
= (Fixed costs + Target operating income)
/ Contribution margin %
Pages 73 - 75

Copyright © 2003 Pearson Education Canada Inc. Slide 3-35
Sensitivity Analysis
• sensitivity analysis is a “what-if” technique that
examines how a result will change if the original
predicted data are not achieved or if an underlying
assumption changes
• What will happen to operating income if volume
declines by 5%?
• What will happen to operating income if variable
costs increase by 10% per unit?
• sensitivity analysis broadens management’s
perspectives about possible outcomes
Pages 76 - 77

Copyright © 2003 Pearson Education Canada Inc. Slide 3-36
Alternative Cost Structures
• CVP helps managers assess the risks and potential
benefits of adopting alternative cost structures
Pages 77 - 78
Example: Alternative rental arrangements
Option 3
20% Commission
Rev
Cost
$
Units
Breakeven = 0 units
Option 2
$1,400 Fixed Fee
+ 5% Commission
Rev
Cost
$
Units
Breakeven = 20 units
Option 1
$2,000 Fixed Fee
Rev
Cost
$
Units
Breakeven = 25 units

Copyright © 2003 Pearson Education Canada Inc. Slide 3-37
Revenue Mix
• Revenue mix (or sales mix) is the relative
combination of quantities of products or services
that make up total revenue
• Sales mix of Do-All : Superword = 2 : 1
Breakeven point in units
= 30 units 20 units of Do-All
10 units of Superword
Do-All Do-All Superword
Pages 73 - 75

Copyright © 2003 Pearson Education Canada Inc. Slide 3-38
Multiple Cost Drivers
• In many cases there may be multiple cost drivers
Do-All Software Example
Variable costs: $40 per software package sold
$15 per invoice issued
Operating income
= Revenue – ($40 x packages sold) – ($15 x invoices
issued) – Fixed costs
• In cases where there are multiple cost drivers there
are multiple breakeven points
Pages 81 - 82

Copyright © 2003 Pearson Education Canada Inc. Slide 3-39
Contribution Margin & Gross Margin
Merchandising Sector
Pages 82 - 83
Contribution Margin
Format
Revenues $200
Variable costs:
Cost of goods sold $120
Other variable 43 163
Contribution margin 37
Fixed costs:
Cost of goods sold 5
Other fixed 19 24
Operating income $13
Gross Margin
Format
Revenues $200
Cost of goods sold (120+5) 125
Gross margin 75
Operating costs (43+19) 62
Operating income $13

Copyright © 2003 Pearson Education Canada Inc. Slide 3-40
Contribution Margin & Gross Margin
Manufacturing Sector
Pages 81 - 82
Contribution Margin
Format
Revenues $1,000
Variable costs:
Manufacturing $250
Non-manufacturing 270 520
Contribution margin 480
Fixed costs:
Manufacturing 160
Non-manufacturing 138 298
Operating income $182
Gross Margin
Format
Revenues $1,000
Cost of goods sold (250+160) 410
Gross margin 590
Non-manufacturing (270+138) 408
Operating income $182

Copyright © 2003 Pearson Education Canada Inc. Slide 3-41
Decision Models and Uncertainty
• Managers make predictions and decisions in a world
of uncertainty
• Estimate events that are likely to occur and assign
probabilities to each outcome
• Probability distribution describes the likelihood of
each mutually exclusive and collectively exhaustive
set of events (must add to 1.00)
• Expected value is a weighted average of the
outcomes with the probability of each outcome
serving as the weight
Pages 86 - 87

Copyright © 2003 Pearson Education Canada Inc. Slide 3-42
Uncertainty Example
Proposal A:
Spy Novel
Page 87
0.5
Probability 0.4
0.3
0.2
0.1
1 2 3 4 5 6 7 8 9
Cash Inflow ($000,000)
Expected value
= (0.1*$300,000) + (.02*$350,000) + (.04*$400,000) +
(0.2*$450,000) + (0.1*$500,000)
= $400,000