Section C: Business Decision Analysis

Chapter 1: Cost Volume Profit Analysis (CVP Analysis)

CVP is used mostly for short-run decisions. CVP analysis enables a company to find the level of production
and sales, both in units and in dollars, required for the company to break even or achieve a specified profit.

CVP analysis assumes that two (and only two) kinds of costs are involved in producing a product i.e., fixed
costs and variable costs.

Fixed Cost
- It remains constant in total regardless of changes in the level of activity within a relevant range.
- Examples of fixed cost are depreciation, rent, salaries, etc.
- Fixed cost is constant in lumpsum but varies at different level of activity, i.e., per unit fixed cost
keeps changing.

Variable Cost
- It is a cost that varies (changes in direct proportion) with the output.
- Variable cost includes direct material, direct labor, variable overheads, etc.
- Per unit variable cost remains constant within the relevant range.

Total Cost = Total Variable Cost + Fixed Cost

Relevant Range
- It is the range of activity within which the variable and fixed cost function remains valid.
- Over the long term, all costs are variable costs.

CVP analysis is also called as Break-Even Analysis and used as a tool for understanding the interaction of
revenues with fixed and variable cost.
Assumptions in CVP Analysis:
1. All costs are either fixed or variable (no mixed/semi-variable costs).
2. Within the relevant range, total costs and revenues are predictable with a linear functional
relationship to output.
3. Total fixed costs, the selling price per unit, variable cost per unit, and the selling mix remain constant
over the relevant range.
4. Production is equal to sales (no changes in inventory).
5. The time value of money is ignored.

Unit Contribution Margin (UCM) & Total Contribution Margin

- The difference between the selling price of a unit and its variable cost is the unit contribution margin.
- The total contribution margin is how much of the sales price is available to cover fixed costs and
then to provide profits after the fixed costs are covered.

Income Statement under CVP for Single Product

Details Per Unit Total
Selling Price/Sales XX XX
Less: Variable Cost (XX) (XX)
Unit Contribution Margin/Total Contribution XX XX
Less: Fixed Cost (XX)
Operating Income XX

Q.1. Prepare Income Statement under CVP Analysis from the following data:
Company X sells 10,000 units at a sales price of $40 per unit. Variable expenses are $12 per unit and fixed
costs total $200,000.

Q.2. Production for Falcon Co. is currently 4,000 units. The sales price and variable cost per unit are $120
and $50 respectively. The annual fixed cost are $1,40,000. These relationships are constant for production
levels up to 10,000 units. Determine operating income for sales of 2,000; 4,000; 6,000; 8,000 & 10,000
units.
Unit Contribution Margin = Unit Selling Price – Unit Variable Cost

Total Contribution Margin = Unit Contribution Margin x No. of units sold

OR
Total Contribution Margin = Total Revenue – Total Variable Cost

Unit Contribution Margin

Contribution Margin Ratio (CMR) =
Unit Selling Price
OR
Total Contribution Margin
Contribution Margin Ratio (CMR) =
Total Revenue

Variable Cost Ratio = 100 – Contribution Margin Ratio (%)

Q.3. Using data of Q.1. calculate Contribution Margin Ratio.

Breakeven Point (BEP) for Single Product:

- It is the level of output/revenue at which total expense equals total cost.
- At BEP, Total Revenue = Total Expense
- At BEP, total contribution margin equals total fixed expenses.
- At BEP all fixed costs have been covered and operating income is zero i.e., is no profit nor loss.

¿ Cost
Breakeven Point (BEP) in units =
Unit Contribution Margin
Breakeven Point (BEP) in revenue ($) = BEP in units x Unit Selling Price
OR
¿ Cost
Breakeven Point (BEP) in revenue ($) =
Contribution Margin Ratio

Breakeven Point will increase in three scenarios:

1. Unit Selling Price is decreasing
2. Unit Variable Cost is increasing
3. Total Fixed Cost is increasing

Breakeven Point will decrease in three scenarios:

1. Unit Selling Price is increasing
2. Unit Variable Cost is decreasing
3. Total Fixed Cost is decreasing

Q.4. Fixed Cost = $15,000; Unit Selling Price = $4; Unit Variable Cost = $2.50. Calculate BEP in units & $.

Q.5. A manufacturer’s product has a unit sales price of $0.6 & unit variable cost $0.2. Fixed costs are
$10,000. Calculate BEP in units & $.

Margin of Safety (MOS)

- It is the excess of budgeted sales over the breakeven sales.

Margin of Safety (MOS) = Planned Sales – Breakeven Sales

OR
Net Operating Income
Margin of Safety (MOS) in $ =
Contribution Margin Ratio

Margin of Safety ( MOS )

Margin of Safety Ratio = x 100
Planned Sales

Up to breakeven point Total Contribution = Total Fixed Cost. Any increase in sales over breakeven point
will result in positive operating income. However, since Fixed Cost remains, the increase in operating
income is directly attributable to increase in contribution margin. In short after/above breakeven point:
Increase in operating income = Increase in contribution from additional units.

Q.6. Using the data of Q.5. and given that planned sales is 25,000 units; calculate MOS (in units), MOS (in
$) and Margin of Safety Ratio.
Q.7. Micheal Scott Paper Company produces office paper. The sales price per ream of paper is $30, the
variable cost per ream is $14 and the total fixed cost is $20,000. If the current sales volume is 2,000 reams of
paper, what is the margin of safety in units and $.

Indifference Point
- It is the point at which management is indifferent to the choice between two options.
- For example, if the option red and option blue both result in operating income of $1,00,000;
management would be indifferent in selecting between the two options

Q.8. Assume a lessor can rent property to either of two lessees. One lessee offers a rental fee of $100,000 per
year plus 2% of revenues. The other lessee offers $20,000 per year plus 5% of revenues. The optimal
solution depends on the level of revenues. At what level the lessor will be indifferent.

Q.9. A college operates a print shop that offers copying services to students for $0.15 per copy. The machine
are leased from a supplier. Labour & Paper cost $0.07 per copy. The supplier who provides the copying
machines makes two offers to the college:
Offer 1: Pay fixed monthly lease of $1400
Offer 2: Pay fixed monthly fee of $200 plus an additional $20 for every 500 copies made.
Required: 1. Calculate indifference point between two offers.
2. Which option to be selected if estimated sales volume is 40,000 copies a month.
Note:
- If the question is talking about expense and if you go below indifference point, choose that option
which has more variable component. And if you go above indifference point, choose that option
which has more fixed component.
- If the question is talking about income and if you go below indifference point, choose that option
which has more fixed component. And if you go above indifference point, choose that option which
has more variable component.

Target Income Calculations

In addition to calculating a breakeven point; CVP analysis is also used to calculate the number of units or
total revenue needed to achieve a targeted level of income.

¿ Costs+Target Operating Income

Target Sales in units =
Unit Contribution Margin

¿ Costs+Target Operating Income

Target Sales in $ =
Contribution Margin Ratio
OR
Target Sales in $ = Target Sales in units x Unit Selling Price

Operating Income = Income Before Tax

Q.10. A manufacturer has a unit sales price of $0.6 & unit variable cost of $0.2. Fixed Costs are $10,000.
Find out how many units must be sold to generate $25,000 of operating income.

Q.11. Fixed Cost = $15,000; Unit Selling Price = $4; Unit Variable Cost = $2.50. Desired before tax net
income of $10,000. Calculate the level of revenue for the desired income.
Q.12. Company X has $4,600 in fixed costs, a selling price of $4.00 per unit, variable cost of $2.20 per unit
and a target pre-tax operating income of $5,000.
1. Calculate the sales volume needed to attain the target pre-tax income.
2. Company X is currently selling only 5,000 units which is not enough to meet its pre-tax operating income.
To increase sales, management is considering a new marketing program that would cost $1,100 and will
increase sales by 500 units. Should the company spend the money on the marketing program?
3. Also, the management wants to know if cutting prices will increase sales enough to generate the required
profits. If the company cuts prices from $4 to $3.75 managers believe they can sell 6,000 units. Determine
whether $0.25 price reduction is sufficient.

Q.13. If units are sold at $6.00 and variable costs are $2.00, how many units must be sold to realize
operating income of 15% ($6.00 × .15 = $.90 per unit) before taxes, given fixed costs of $37,500?

Target Net Income

Net Income = Operating Income (Income before tax) – Tax Expense

A variation of the problem asks for the net income (after tax income) instead of operating income.
 ¿ Costs+[Target Net Income/(1−tax rate)]
Target Net Income Sales in units =
Unit Contribution Margin

¿ Costs+[Target Net Income/(1−tax rate)]

Target Net Income Sales in $ =
Contribution Margin Ratio
OR
Target Net Income Sales in $ = Target Net Income Sales in units x Unit Selling Pric

In the problem that ask for breakeven point, net income will be zero, so any income tax rate
information given is irrelevant.

Q.14. A manufacturer has a unit sales price of $0.6 & unit variable cost of $0.2. Fixed Costs are $10,000.
Find out how many units must be sold to generate $30,000 of net income. The effective tax rate is 40%.

Q.15. If variable costs are $1.20, fixed costs are $10,000, and selling price is $2, and the company targets a
$5,000 after-tax profit when the tax rate is 30% then what will be the revenue to achieve the target revenue?

Q.16 Q. Sales price per unit is $125 and variable cost per unit is $50. Fixed cost are of $1,50,000. Desired
pre-tax profit is $60,000 and tax rate of 40%. Potential unit sales of 2500 units at current sales price & a
maximum of 3000 units to reach market saturation.
1. Calculate breakeven point in units and value.
2. Calculate unit sales needed to achieve its desired pre-tax profit and after tax profit.
3. Calculate profit if company sells 2500 units.
4. Calculate per unit sales price needed to produce its desired pre-tax profits given the market saturation
level of 3000 units.
Q.17 Selling Price is $4.00; Variable cost are $2.20 per unit & Fixed cost = $4,600. Calculate:
1. Total sales to earn pre-tax profit of 35% of sales.
2. Given tax rate of 30%, what will be total sales to earn after tax net profit of 20% of revenue.

CVP Analysis for Multi-Product Calculations

- To use CVP analysis when more than one product is sold, assume that the company has a constant
sales mix otherwise there is no single point at which breakeven will occur.
- The sales mix is the percentage of sales that each of the products and services represents of total
sales.
- Assuming that different products have different contribution margin ratios, the sales mix determines
the overall contribution margin ratio which in turn determines the number of units and level of
revenues needed to breakeven.
- Selling more of relatively higher contribution margin products result in a lower breakeven point.

¿
Multiproduct BEP in units = Total ¿Cost Weighted Average Unit Contribution Margin

Weighted Average Unit Contribution Margin = Weighted Average Unit Selling Price – Weighted Average
Unit Variable Cost

¿
Multiproduct BEP in $ = Total ¿Cost Weighted Average Contribution Margin Ratio

Weighted Average Unit Contribution Margin

Weighted Average Contribution Margin Ratio =
Weighted Average Unit Selling Price

- The weighted-average selling price and weighted-average variable costs are calculated using the
individual product sales percentages in the total sales mix.
- The multi-product breakeven point provides the company’s overall breakeven point, which is a
mixture of all the different products. From this, individual breakeven points can be calculated.

Q.18. A manufacturer has two products, Product V and Product W. Total fixed costs are $75,000. Variable
cost and sales data for these products are as follows:
 Product V Product W
Selling price per unit $10 $18
Variable cost per unit $7 $14
Budgeted sales units 6,000 18,000
Calculate multi-product breakeven in units and $

Note: The percentage breakdown of products by number of units and percentage breakdown of products by
revenue will not be the same when company sells multiple products at different selling price.
Q.19. A company sells two products, Fix & Brix. Following are the revenues and costs budgeted for the
coming year:
Fix Brix
Budgeted Sales in Units 50,000 1,50,000
Unit Selling Price 20 10
Direct Material Per Unit 2 1
Direct Labor Per Unit 3 2
Variable OH per unit 2 2
Fixed OH is budgeted for the year is $6,00,000
1. Calculate breakeven is dollars and units. Assume that the company will maintain the sales mix as
budgeted.
2. Calculate breakeven is dollars and units. Assume that the direct materials cost per unit of Fix
increases from $2 to $3.
3. Calculate breakeven in dollars and units assuming the quantity sold of Brix is 2,00,000 instead of
1,50,000.
Composite Units
- Refers to multiple products sold as one unit (one basket of multiple products). Ex – shampoo, hairoil
and conditioner sold as one unit.
- Calculation of BEP of composite unit:
o Calculate UCM of each product
o Calculate total contribution of reach product
o Take grand total of total contribution margin as calculated in step 2
¿
o BEP (composite unit) = Total ¿Cost Grand Total of total contribution marginof each product
- And to get multiple product BEP = BEP (composite unit) x Total units of all products

CVP Analytical Tools

- Since CVP analysis is used for decision-making, it necessarily involves assumptions about the future.
This introduces the elements of risk and uncertainty into the process.
- Managers may also use CVP analysis to forecast the effects of many types of operating changes and
to determine whether a firm has an operating cushion that can absorb sudden downturns in the
economy.
- When managers have this type of information, they are better able to make operational decisions.

Sensitivity Analysis
- Given the necessary uncertainty surrounding CVP inputs (price, volume, variable cost and fixed
cost), using sensitivity analysis you can determine the impact of changes in each input with respect
to breakeven or some other minimal
- By looking at how much the results change as an assumption change, the decision-maker can identify
critical factors that must be controlled as much as possible. With CVP analysis, the underlying
assumptions will include sales volume, selling prices, and costs.
- The objective of sensitivity analysis is to identify the CVP input that has the greatest impact on the
profit in terms of potential change in the input.
Other Decisions
1. Choosing between two cost options
In some cases, management must choose between two ways of accomplishing the same thing that
have different costs.

2. Choosing between two production options

CVP analysis and the concepts of marginal analysis can help a company decide which product to
produce to maximize profits when it can produce only one product out of two possible products.

3. Using Fixed or Variable Inputs

This is fundamentally the same as the discussion for two cost options.

4. Product Mix Decisions Under Constraints

A constraint or limiting factor may eliminate a few possible solutions because they are not feasible in
the short run due to the constraint. In the decision-making process, this limiting factor must be kept
in mind and appropriately addressed. When production is operating at capacity, operating income is
maximized by maximizing the contribution margin per unit of the constrained resource.

Q.20. Hanover Inc, provides landscape design consulting. The rate is expected to be $56 per hour, but
market demands rate adjustments. Variable cost per hour are estimated to be $32 and total fixed cost at
$,800,000. Annual sales volume is projected to be 40,000 hours. Hanover management wants to understand
how sensitive operating profit is to unexpected shifts down of prices and sales volumes, and cost increase by
as much as 5%.

Q.21. Zak and company builds office chairs. Projected price, costs & volume data for one of its product are:
Price - $460; Variable Cost - $380 per chair; Total fixed cost - $2,50,000; Sales volume: 4,000 units. Either
the price or variable cost could differ as much as $10 per unit. Fixed costs may turn out to be 10% higher.
Sales volume might be as many as 1000 chairs. How sensitive is the breakeven goal to the range of estimates
on price, variable cost, fixed cost or sales volume.
Q.22. Fixed cost = $15,000, unit selling price = $4, unit variable cost = $2.50, Assume supply of certain raw
material is becoming scarce and management is expecting an increase in price of this product to increase
variable cost per unit by 10%. Calculate the effect on breakeven.

Solutions

Solution 1:
Details Per Unit Total
Sales 40 400,000
Less: Variable Cost (12) (120,000)
Contribution Margin 28 280,000
Less: Fixed Cost (200,000)
Operating Income 80,000

Solution 2:
2,000 4,000 6,000 8,000 10,000
Sales 2,40,000 4,80,000 7,20,000 9,60,000 12,00,000
Less: Variable Cost (1,00,000) (2,00,000) (3,00,000) (4,00,000) (5,00,000)
Contribution 1,40,000 2,80,000 4,20,000 5,60,000 7,00,000
Less: Fixed Cost (1,40,000) (1,40,000) (1,40,000) (1,40,000) (1,40,000)
 Operating Income Nil 1,40,000 2,80,000 4,20,000 5,60,000

Solution 3: CMR = 28/40*100 = 70%

Solution 4: BEP in units = 15,000/1.5 = 10,000 units

BEP in $ = 10,000 x 4 = $40,000

Solution 5: BEP in units = 10,000/0.4 = 25,000 units

BEP in $ = 25,000 x 0.6 = $15,000

Solution 6: MOS (in units) = 25,000 – 10,000 = 15,000 units

MOS (in $) = 15,000 x 0.6 = $9,000
Margin of Safety Ratio = 9,000/25,000*100 = 36%

Solution 7: BEP (in units) = 20,000/16 = 1,250 units

MOS (in units) = 2,000 – 1,250 = 750 units
MOS (in $) = 750 x 30 = 22,500

Solution 8: $100,000 + .02R = $20,000 + .05R

.03R = $80,000
R = 80,000/.03
R = $2,666,667
Where R = Indifference Point

Solution 9: 1,400 = 200 + (20C/500)

1,200 = 0.04C
C = 30,000 copies

Solution 10: Target operating income in units = (Fixed costs + Target operating income) ÷ UCM = ($10,000
+ $25,000) ÷ $0.40 = $35,000 ÷ $0.40 = 87,500 units

Solution 11: Target Units = (15,000+10,000)/1.5 = 16,667 units.

Target Revenue = 16,667 x 4 = 66,666

Solution 12:
1. Target Sales Volume= (4,600+5,000)/1.8 = 5,334 units.
Target Revenue in $ = 5,334 x 4 = 21,336
2. Sales (5500 x 4) 22,000
Less: Variable Cost (5500 x 2.20) (12,100)
Contribution 9,900
Less: Fixed Cost (4,600+1,100) (5,700)
Operating Income 4,200
At 5,000 units, the operating income is 4,400 so it does not make sense to increase the marketing
spend.
3. Sales (6000 x 3.75) 22,500
Less: Variable Cost (6000 x 2.20) (13,200)
Contribution 9,300
Less: Fixed Cost (4,600)
Operating Income 4,700
Since operating income is 4,700 less than the target income of 5,000; the reduction in price is not
sufficient.

Solution 13: Operating Income = Sales – Variable Cost – Fixed Cost

0.9 x Q = (6 x Q) – (2 x Q) – 37,500
3.10 x Q = 37,400
 Q = 12,097 units

Solution 14: Target unit volume = [$10,000 + ($30,000 ÷ .60)] ÷ $.40 = 150,000 units.

Solution 15: Target unit volume = [10,000 + (5,000 ÷ 0.70)] ÷ 0.8 = 21,428 units
Target revenue = $42,856

Solution 16:
1. BEP (in units) = 1,50,000/75 = 2,000 units. BEP (in $) = 2,000 x 125 = $2,50,000
2. Target Volume for OI = (60,000 + 1,50,000)/ 75 = 2,800 units; Revenue = 2,800 x 125 = 3,50,000. Target
After tax will same as above
3. OI at 2,500 = 2,500 x 75 – 1,50,000 = 37,500 – Tax @ 40% = 22,500
4. CMR = 75/125 = 0.6. Target Revenue = (60,000 + 1,50,000)/0.6 = 3,50,000.
Target SP = 3,50,000/3,000 = 116.67.

Solution 17:
1. Let the number of units sold be R
Target Pretax Profit = 35% x 4R = 1.4R
1.8R – 4600 = 1.4R
R = 11,500 units. Target Revenue = 11,500 x 4 = $46,000
2. Net Income = 20% x 4R = 0.8R
Target Units = [4600 + (0.8R/1-0.3)]/1.8
R = (4600 + 1.143R)/1.8
1.8R = 4600 + 1.143R
R = 7000 units; Revenue = 7000 x 4 = $28,000

Solution 18:

Solution 19:
Solution 20:
Solution 21: