Module 02

Business Plan: Cost-Volume-Profit

Module 02

Business Plan: Cost-Volume-Profit Analysis (Chapter 2)

Overview

A business plan shows the direction that a business will take during
the next year. Accountants are involved in the Financial Plan. CostVolume-Profit analysis assists with determining the projected profit.

Objective
and
Learning
Outcomes

To discuss the theory and applications of cost-volume-profit analysis.

When you have completed your study of this module, you should be
able to:
LO 1: Explain the purpose of a business plan.
LO 2: Explain CVP Analysis
LO 2.1: Identify and explain cost behaviour patterns.
LO 2.2: Predict costs using the High-Low method.
LO 2.3: Calculate profit.
LO 2.4: Calculate the contribution margin.
LO 3: Use the CVP analysis for breakeven and what-if analyses.
LO 4: Explain and assess operating risk.

Learning
Resources

Workshop Preparation (attempt the questions before class):

Course Book: Problem Module 01 Review Questions. (See
Module 01)
Lecture Preparation:
Textbook: Chapter 2
Course Book: Problems Jan Carter: The High-Low Method, Ideal
Car Groom & Operating Leverage.
Additional Material:
Textbook: Testing Your Knowledge 2.11, 2.12, 2.13, 2.14, 2.15 &
2.16.
Textbook: Applying Your Knowledge 2.19, 2.20, 2.21, 2.22, 2.23,
2.26, 2.28, 2.29, 2.30 & 2.31.
Textbook: Making evaluations 2.40.
Course Book: Problems Cost-Volume-Profit Analysis & Payment
Options.

In this section
Lecture Overheads: Cost-Volume-Profit Analysis
Problem: Jan Carter: The High-Low Method
Problem: Ideal Car Groom
Problem: Operating Leverage
Problem: Cost-Volume-Profit Analysis
Problem: Payment Options
Workshop Problem: Tasman Ski Lodge
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Module02 CVP(Chapter2)

Module 02 Chapter 2

Developing a Business
Plan: Cost-Volume-Profit
Analysis

Objective and Learning Outcomes

To discuss the theory and applications of costvolume-profit analysis.
When you have completed your study of this module,
you should be able to:
LO 1: Explain the purpose of a financial plan.
LO 2: Explain CVP Analysis
LO
LO
LO
LO

2.1:
2.2:
2.3:
2.4:

Identify and explain cost behaviour patterns.

Predict costs using the High-Low method.
Calculate profit.
Calculate the contribution margin.

LO 3: Use the CVP analysis for breakeven and whatif analyses.

LO 4: Explain and assess operating risk.
2

LO 1: The Financial Plan

Identifies the business capital requirements.
What assets are required, when, and whats their cost?
Projects operating cash flows to determine additional
capital requirements.

Identifies the business sources of capital.

Short-term capital sources: repaid within a year.

Suppliers

Banks, e.g., line of credit

Long-term capital sources

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Module02 CVP(Chapter2)

LO 1: The Financial Plan (2)

Describes the business projected financial
performance.
Uses modified historical data (more difficult for start-ups
like Sweet Temptations).
Will include budgets and projected financial statements
(next module), supported by cost-volume-profit (CVP)
analysis.
CVP is a type of what if analysis.

LO 2: C-V-P Analysis
C-V-P analysis shows how profit will be
affected by alternative sales volumes, selling
prices, and costs.
In doing this, C-V-P analysis makes certain
simplifying assumptions about how costs and
revenues respond (behave) when sales
volume changes.

LO 2.1.1: Cost Behaviour - Fixed costs

Fixed costs remain the same in total as sales volume
changes, with the understanding
That as time goes by, total fixed costs could change.
That, even holding time constant, total fixed costs could
change outside a relevant range of sales volume.

For example, beyond existing capacity, total fixed costs could

increase.

Within that relevant range, fixed unit costs vary inversely with
changes in sales volume.

Although CVP analysis uses exclusively sales volume

to predict cost behaviour, other volume measures
can be used in contexts other than CVP, e.g., labour
6
hours worked to predict total labour $$$.

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Module02 CVP(Chapter2)

LO 2.1.1: Cost Behaviour Fixed Costs (2)

A graphical depiction of relevant range.

Sales Volume

LO 2.1.1: Cost Behaviour - Fixed costs (3)

Fixed cost behaviour for Sweet Temptations (linear)

= $1,100/month

$11 per unit sold

$1.1 per unit sold8

LO 2.1.2: Cost Behaviour Variable costs

Variable costs change in total in proportion to
changes in sales volume. Again, this conclusion
holds
For a specific time period,
Within the relevant range,
Using sales volume as the cost predictor.

Under these same assumptions, variable costs per

unit are constant as sales volume changes.

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Module02 CVP(Chapter2)

LO 2.1.2: Cost Behaviour Variable costs (2)

Variable cost behaviour for Sweet Temptations (linear)

1000

10

LO 2.1.3: Cost Behaviour Mixed Costs

Mixed costs have both variable and fixed cost components.
For CVP analysis, accountants make two additional
assumptions with respect to mixed costs:

That they can be separated into their fixed and variable portions.

That those portions, when separated, are linear (like fixed and
variable cost behaviour) within the relevant range of sales
volume.

11

LO 2.1.4: Cost Behaviour Total Costs

Total costs at any sales volume are the sum of the
fixed costs and the variable costs at that volume.
The equation for the total cost is:

Total
cost

FC

VC(x)

where: FC = total fixed costs

VC = variable cost per unit sold
x = sales volume
12

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Module02 CVP(Chapter2)

LO 2.1.4: Cost Behaviour Total Costs (2)

Total cost behaviour for Sweet Temptations

13

LO 2.2: Cost Prediction Under CVP

A linear cost function (for a single cost or for total
costs within the relevant range) can be
approximated in several ways:
By using a scatter diagram.
By using a statistical tool called regression
analysis.
By using a simplified tool called the high-low
method.

14

LO 2.2: Cost Prediction Under CVP (2)

Cost
($)

Sales Volume

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Module02 CVP(Chapter2)

LO 2.2: Cost Prediction High-Low Method

Steps in the High-Low Method:

1. Calculate variable cost per unit of

activity
Variable
Cost per
Unit of Activity

Cost associated with

Cost associated with
{ Highest
activity level - Lowest activity level }
Highest activity level - Lowest activity level

In CVP, activity is sales volume.

16

LO 2.2: Cost Prediction High-Low Method (2)

2. Calculate Total Fixed Costs
Total cost (at highest volume level) (VC per unit x highest
volume level) = Fixed Costs

OR
Total cost (at lowest volume level) (VC per unit x lowest
volume level) = Fixed Costs

3. Summarize by writing a linear equation

TC = FC + VC(x), where x = volume

17

LO 2.2: Cost Prediction High-Low Method (3)

High- Low Method Example:
Company A has total costs of $150,000 at 500 units of output
and $400,000 at 3,000 units of output. Calculate the variable
and fixed costs.

18

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Module02 CVP(Chapter2)

LO 2.2: Cost Prediction High-Low Method (4)

Jan Carter: The High-Low Method

(Course Book Problem)

19

LO 2.3: Profit calculation

One way of graphing a business profit is to show its
revenues and expenses on the same graph.
The graph of a business revenues is shown by a
straight line sloping upward from the originin order to
keep the revenue line straight, selling price is assumed
to remain constantanother CVP assumption.
The graph of a business total costs includes its fixed
costs and variable costs.
The unit sales volume at which a business earns zero
profit is called the break-even point.
20

LO 2.3: Profit calculation (2)

$

Relevant
range
Breakeven
Point

Sales Revenue

PROFIT
Total costs
Variable costs

LOSS
Fixed costs

Sales Volume
21

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Module02 CVP(Chapter2)

Sweet
Temptations

LO 2.4: Contribution margin

Contribution margin equals the difference between
estimated total sales revenue and estimated total
variable costs.
The amount of revenue remaining after subtracting the
total variable costs will contribute to covering the
estimated fixed costs.
The contribution margin per unit is the difference
between the estimated sales revenue per unit and the
estimated variable costs per unit.

23

LO 2.4: Contribution margin (2)

The contribution margin is a critical concept.

Why is it called contribution margin?

Fixed
Costs

24

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Module02 CVP(Chapter2)

LO 2.4: Contribution margin (3)

Per unit
CM per unit = Sales price VC per unit
In total
Total $ sales Total $ variable costs
As a ratio (per dollar of revenue)
CM per unit
Selling price

or

Total $ CM
Sales Revenue
25

LO 2.4: Contribution margin (4)

At Greenfarms Ltd. the selling price per unit
for wheel barrows is $120, variable cost per
unit is $55. Fixed costs are $130,000. The
contribution margin per unit is?
a. $65
b. $75
c. $175
d. $30
26

LO 2.4: Contribution margin (5)

Contribution Margin Income Statement

27

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Module02 CVP(Chapter2)

LO 3: Using C-V-P analysis

C-V-P analysis is useful in planning because it
shows the impact of alternative plans on profit.
Common uses:
To estimate profit at a given unit sales volume;
To find the unit sales volume necessary to
achieve a target profit;
To find the break-even point.
28

LO 3: Using C-V-P analysis (2)

The following equation will answer: how many sales
units do we need to achieve a given target pre-tax
profit, given our current cost structure?

SP(x) VC(x) FC = estimated profit (pre-tax),

where x = sales volume in units. Algebraically reduced:

(x) =

Pre-tax Target Profit + FC

CM per unit
29

LO 3: Using C-V-P analysis (3)

A variation on the previous question: How many sales
units to breakeven?
Just set the target profit to zero:

Breakeven Point = (x) =

Fixed Costs
CM per unit

More variations: what if one or more of the variables

changed? What effect on profit? On the BE point?

30

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Module02 CVP(Chapter2)

LO 3: Using C-V-P analysis (4)

Costvolumeprofit relationships for Sweet Temptations

31

LO 4: Operating Risk

Operating risk is the exposure a company faces from

sales being lower than expected. It is a function of
fixed costs and contribution margin.

In general, the higher the fixed costs relative to variable costs,

the greater the operating risk.
A companys mix of fixed costs and variable costs is referred to as
its cost structure.

One tool for assessing operating risk is the margin of

safety, which compares the actual or planned sales
level with the breakeven point.

Can be measured in sales units or dollars.

Can be measured as a % decrease:

MOS = actual or planned sales - breakeven point

actual or planned sales

32

LO 4.1: C-V-P analysis and Operating risk

Ideal Car Groom (Course Book Problem)

33

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Module02 CVP(Chapter2)

LO 4.2: Operating Leverage

Another tool for assessing operating risk is operating
leverage or operating gearing.
A business operating leverage is another way to look at a
its exposure to a decline in sales.
For a given sales volume, the greater the proportion of fixed
costs to total costs, the greater the operating leverage and
operating risk at that sales volume.

Operating Leverage (Course Book Problem)

34

Additional Questions for Self-Study

Testing Your Knowledge (Textbook):
Questions: 2.11, 2.12, 2.13, 2.14, 2.15 & 2.16.
Applying Your Knowledge (Textbook):
Questions: 2.19, 2.20, 2.21, 2.22, 2.23, 2.26,
2.28, 2.29, 2.30 & 2.31.
Making Evaluations (Textbook):
Question: 2.40.

35

Additional Questions for Self-Study (2)

Cost-Volume-Profit Analysis (Course
Book Problem)
Payment Options (Course Book Problem)

36

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Module02 CVP(Chapter2)

Workshop
Review of Cost-Volume-Profit Analysis
(Module 02)
Tasman Ski Lodge (Course Book Problem)

37

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Learning Resources
ACCTG 101

Problem

Jan Carter: The High-Low Method

Scenario
Jan Carter owns and operates a small retail outlet, Jans Clothing Ltd, located at Eden Park. She sells
rugby jerseys to rugby fans. Jan has been thinking about the controversy in the newspaper lately
regarding the high cost of All Black jerseys in New Zealand compared to the prices that they fetch
overseas. She notes that Rod Duke, general manager of Rebel Sport and Briscoes, is also upset at the
price difference between New Zealand and other overseas markets.
As she is a huge All Black supporter, she would like to sell the jerseys for a cheaper price to her loyal
customers. Before making any decisions however she needs to investigate and understand how
changes in prices and costs as well as volume affect the profitability of her business.
She has approached you for help and has supplied you with the following information:

Volume (number
of rugby jerseys)
Sales Revenue
Costs
Operating Profit

May

June

July

August

170

150

230

315

$37,400

$33,000

$50,600

$69,300

($21,050)

($19,280)

($27,880)

($34,955)

$16,350

$13,720

$22,720

$34,345

Note There were no price changes of any description during these four months.
Required
1

Calculate Jans selling price per rugby jersey.

Estimate the variable cost per jersey and monthly fixed costs using high-low
analysis.

Explain why it is necessary to use the high-low method to calculate the variable
and fixed costs in this scenario.

Explain the high-low method using a mathematical proof.

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Learning Resources
ACCTG 101

Problem

Ideal Car Groom

Costs for business activities may be broadly divided into those that are fixed relative to the level
of activity and those that vary with changes in the level of activity. If we can estimate the
relationship between volume of activity, costs and profit, then we can use this knowledge to
make decisions and assess risk, particularly in the context of short-term decisions.

Scenario
Jake Lyons recently purchased Ideal Car Groom, an outlet providing a standard car wash and
grooming service. The business is expanding and Jake realises he needs to know and
understand more about how changes in prices and costs as well as volume affect the
profitability of the business. Summarised results for the past three months reveal the following:
January

February

March

1,200

1,450

1,625

$37,440

$45,240

$50,700

39,060

42,940

45,435

$ 2,300

$ 5,265

Volume (number of services provided)

Sales revenue
Costs
Operating profit

$ (1,620)

Required
1.

Behaviour of costs:
(a)

(b)

2.

For this business, give some examples of costs that are likely to be
(i)

Fixed

(ii)

Variable

(iii)

Mixed (semi-variable).

Will fixed costs stay the same irrespective of time and level of output? Will the
slope of the variable cost line always be constant? Explain with examples.

Cost estimation:
(a)

Using the high-low method, estimate the variable cost per service provided and the
total fixed costs per month.

(b)

If Jake has predicted that this months activity will be 1,750 services provided, what
is the estimated total cost for April?

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Problem: Ideal Car Groom

3.

Breakeven analysis:
How many services must Ideal Car Groom provide and sell each month to breakeven?

4.

Profit planning and risk assessment:

(a)

Based on the expected activity of 1,750 services provided:

(i)

What is the expected profit for the month of April?

(ii)

What is the margin of safety? Explain why Jake might find this information
useful.

(b)

Jake wants to achieve a monthly profit of $10,000. What monthly sales volume is
required?

(c)

Jake is considering the possibility of establishing a quality improvement

programme that will require a $1.80 increase in the variable cost per unit. To
inform customers of the quality improvements, Jake plans to spend an additional
$2,600 per month for advertising.
(i)

Calculate the new monthly breakeven volume.

(ii)

Calculate the volume required to achieve the target profit of $10,000 per
month.

(iii)

Should Jake proceed with plans to improve service quality? Explain.

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Learning Resources
ACCTG 101

Problem

Operating Leverage
Scenario
Ridge Company and Ellis Company are two competing firms offering a mini-bus service from
Mangere Airport. While Ridge pays most of its employees on a per-ride basis (variable cost),
Ellis prefers to pay its employees fixed salaries (fixed costs). Information about the price and
cost structures of the two firms is given below.
Ridge Company

Ellis Company

Selling price per ride

$60

$60

Variable cost per ride

$48

$30

$30,000

$165,000

Fixed costs per year

Required
1

Breakeven Analysis
(a) Calculate the annual breakeven point in number of rides for each firm.

Profit-Volume Graphs
(a) Prepare a profit-volume graph for each firm by plotting profit as a function of the
number of rides.

(b) At what number of rides will the firms have the same profit?

Profitability and Risk

(a) Explain which firms cost structure is more profitable.

(b) Explain which firms cost structure is financially riskier.

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Learning Resources
ACCTG 101

Problem

Payment Options
Scenario
Big Business Productions, a major producer of business videos for the corporate and academic
market, is interested in producing a sequel to hit video Budgeting. The company has
approached you to star in the new video called Back to Budgeting and has offered you the
choice of two payment options:
Option One:
A fixed fee of $80,000.
Option Two:
A fixed fee of $30,000 plus 15% of the revenue Big Business Productions receives for
the video.
Big Business Productions estimates that production costs (excluding payments to you) will be
$120,000. A&B Publishers have agreed to market Back to Budgeting. A&B expects to spend
$40,000 and will be paid 20% of the revenues Big Business Production receives.

Required
1 How much revenue from selling Back to Budgeting does Big Business Productions
need to generate to break-even under each of the two payment options?

2 What is the operating profit for Back to Budgeting under each of the two payment
options if Big Business Productions grosses $1,000,000 in revenue?

3 As the actor, which payment option would you choose? Explain why you would make
this choice identifying the advantages and disadvantages of each option.

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Learning Resources
ACCTG 101

Problem

Cost-Volume-Profit Analysis
Scenario 1
Hauraki Industries produce only one product. The following revenue and costs have been
estimated for the forthcoming month
Selling price

$70 per unit

Variable costs

$40 per unit

Total fixed costs

$2,400

Estimated sales

220 units

Required
The managers of the firm wish to know the following:
1

How many units need to be sold to breakeven?

By what percentage can sales drop before a loss occurs?

How many units must be sold to make a profit of $6,000?

Would it be worthwhile to introduce advertising at a cost of $1,200 if this will increase

sales from 220 to 300 units?

What should the selling price be to make a profit of $8,640 on sales of 120 units?

Suppose the selling price per unit decreases by 10% while the variable costs per unit
increase by 20% and monthly fixed costs by 25% in total. How many units must be
sold in order to make a profit of $2,250?

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Problem: Cost-Volume-Profit Analysis

Scenario 2
1.

Complete this table by filling in the missing figures.

Example 1

Example 2

Example 3

Example 4

10,000

10,000

9,862

$31

Quantity

Selling price per unit

$12

$12

Variable cost per unit

$4

$10

Total Fixed Cost

$60,000

$10,000

Total Sales

Total Variable Costs

Contribution per unit

Total Contribution

Operating Profit

10

Contribution Margin
ratio (%)

11

Variable cost ratio

12

Variable cost ratio

+ Contribution margin ratio

13

Break-even point in units

14

Break-even Sales Value ($)

15

Margin of Safety in units

16

Margin of Safety in Dollars

17

Margin of Safety Ratio (%)

$27

$276,039

50%

12,486.22

A
$143,771

$340,830

Tip: To complete columns 3 and 4, you should first calculate the missing figures A, B, and C.

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Learning Resources
ACCTG 101

Problem

Tasman Ski Lodge

Scenario
Tasman Ski Lodge has 10 rooms that it provides as budget accommodation to tourists. During
peak season, about three months of each year, the rooms are all fully booked. The occupancy
rate is very low during the rest of the year. The following is a summarised income statement
for the year ending 28 February 20X1: (1 room-day = 1 room let for one day).
Season

Autumn

Winter

Spring

Summer

Total

920

920

910

900

3,650

92

920

182

270

1,464

$4,140

$41,400

$8,190

$12,150

$65,880

7,150

7,150

7,150

7,150

28,600

Breakages and maintenance

760

4,900

1,210

1,650

8,520

Cleaning and laundry

920

9,200

1,820

2,700

14,640

Electricity

460

4,600

910

1,350

7,320

$9,290

$25,850

$11,090

$12,850

$59,080

$(5,150)

$15,550

$(2,900)

$ (700)

$ 6,800

Occupancy:
Total room-days available
Room-days let
Revenue (@ $45 per room)
Less Costs:
Administration and lease costs

Total Expenses
Profit (Loss)

The owners of Tasman Ski Lodge are concerned about the lack of profit in the off-seasons and
wish to consider alternatives such as charging higher rates or closing completely during these
seasons.

Required
1.

Use the cost amounts and room-days let from the above income statement to identify and
explain which cost items are:
(a) Pure fixed costs
(b) Pure variable costs
(c) Mixed or semi-variable costs

2.

Estimate the amount of fixed cost per season and variable cost per room-day. Use the
total costs and volumes for autumn and winter seasons (high-low method) to separate the
costs into fixed and variable elements.

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Problem: Tasman Ski Lodge

3.

How many room-days must Tasman Ski Lodge let per year in order to make an annual
profit of $25,000?

4.

One option to improve profitability is to set a new rate for the autumn, spring and
summer periods that would at least cover the total costs incurred during these seasons.
Calculate the room rate required (based on the current volume) to breakeven during the
nine-month period. How appropriate is this option?

5.

It has been suggested that Tasman Ski Lodge should charge a discounted rate $35 per
room-day during Spring, Summer and Autumn seasons and increase the rate during the
Winter season. It is estimated that the discounted price would increase the occupancy
rate during the off-season by 75%. How much will they have to charge per room-day
during the Winter in order to achieve the annual target profit of $25,000?

6.

What strategy do you think the owners should follow in order to improve profitability?
Explain your answer.

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