CHAPTER - ONE

COST- VOLUME- PROFIT ANALYSIS (CVP-ANALYSIS)

Upon completing this chapter the learner will be able to:
 Distinguish variable and fixed cost behavior and patterns
 Compute a break-even point in total Birr and total units using the
contribution margin approach and the equation approach.
 Prepare a cost-volume –profit graph, and explain how it is used.
 Applying CVP analysis to determine the effect on profit of changes in
fixed expenses, variable expenses, sales prices, and sales volume.
 Explain the key assumption of CVP analysis.
 Identify limitation of CVP analysis
1.1 INTRODUCTION
Cost-volume-profit (CVP) analysis is one of the most powerful tool that help
managers as they make decisions by facilitating quick estimation of net income at
different levels of activity. In other words, it helps them to understand the
interrelationship between cost, volume, and profit in an organization by focusing
on interactions between the following five elements: prices of products, volume or
level of activity, per unit variable costs, total fixed costs, and mix of products sold.
CVP analysis helps managers to understand the interrelationship between cost,
volume, and profit. So, it is a vital tool in many business decisions. These
decisions include, for example, what products to manufacture or sell, what
pricing policy to follow, what marketing strategy to employ, and what type of
productive facilities to acquire.
1.2 Variable and Fixed Cost Behavior, and Patterns
Cost behavior is the manner in which a cost changes as a related activity
changes. The behavior of cost is useful to managers for variety of reasons. For
example, to predict profit as sales and production volume changes, to estimate
cost which affect a variety of decisions. Understanding the behavior of cost
depend on cost drivers and its relevant range.

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Variable costs are costs that vary in proportion to change in activity base. When
activity base is unit produced direct materials and direct labor is classified as
variable cost.
Fixed costs are costs that remain the same in total cost amount as the activity
base changes. When activity base is units produced many factory overhead costs
such as straight line depreciation is classified as fixed cost.
The relevant range is the range of activity where the assumption that cost
behavior is a straight line (linear) is reasonably valid. Managerial accountants like
to assume that the relationship between a cost and an activity run in a straight
line. As an example, if you make 10 widgets, and the direct materials in the
widget cost $1, then the assumption would be that for each widget above 10, you
would need to purchase another $1 worth of direct materials.
What might make this not be the case? Perhaps, there is a discount on additional
direct material at a given point. So from a relevant range standpoint, we need to
determine at what point that number will change. Perhaps we get a discount after
we purchase 100 components, at which time the cost of direct material will drop
to .80 per widget. With variable costs then, the relevant range will be the range
where the cost of adding one more, will be the same as the last. In this example,
from 0-100 widgets, each additional widget will add $1 in cost to our direct
materials. Once we go above 100, we are outside of the relevant range.
In fixed cost the supervisors salary is fixed let us say $12,000 and suppose two
machines are producing 500 units each per year and supervised by one
supervisor. However this he can supervise three additional machines installed
nearby him. Therefore till the company requirement is to produce 2500 (500*5)
units per year the same supervisor will hand it. As a result the cost of supervisor
remains fixed. But if the company wants to produce more than 2,500 units per
year in required to be appointing another supervisor for 6 th machine. Therefore
the supervisor’s salary will be fixed till the production range is 2,500 units.
A. Contribution Margin versus Gross Margin
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
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ended January 31, 2006. This income statement is called contribution approach
to income statement. The contribution income statement emphasizes the behavior
of the costs and therefore is extremely helpful to manager in judging the impact of
changes in selling price, cost, or volume on profits.
Exhibit 1.1

ABC Trading
Projected Income Statement
For the Month Ended January 31,2006
Total Per unit
Sales (10, 000 units) Br. 150, 000 Br.15
Variable Expenses 120, 000 12
Contribution Margin Br. 30, 000 Br. 3
Fixed Expenses 24, 000
Net Income Br. 6,000

In the income statement here above, sales, variable cost, and contribution margin
are expressed on a per unit basis as well as in total. This is commonly done on
income statements prepared for management’s own use since it facilitates
profitability analysis.
The contribution margin represents the amount remaining from sales revenue
after variable cost has been deducted. Thus, it is the amount available to cover
fixed cost and then to provide profit for the period.
The per unit contribution margin indicates by how much Birr 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. 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(15,000- 24,000). 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
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reach this point (called break-even point), the company will have to sell 8, 000
units in a month, since each unit sold yield Br. 3.00 in contribution margin.

ABC Trading
Projected Income Statement
For the Month Ended January 31,2006
Total Per unit
Sales (8, 000 units) Br. 120, 000 Br.15
Variable Expenses 96, 000 12
Contribution Margin Br. 24, 000 Br. 3
Fixed Expenses 24, 000
Net Income Br. 0

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.
B. 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:

ABC Trading
Projected Income Statement
For the Month Ended January 31,2006
Total Per unit Percentage
Sales (10, 000 units) Br. 150, 000 Br.15 100%
Variable Expenses 120, 000 12 80%

Contribution Margin Br. 30, 000 Br. 3 20%

Fixed Expenses 24, 000
Net Income Br. 6,000

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:
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 CM-ratio= Contribution Margin or
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%.
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.
1.3 Break Even Analysis Uses and Techniques
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 to 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:
 Equation technique,
 Contribution margin technique and
 Graphical method.
Equation Technique: 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.
Profit= Sales revenue-Variable expenses-Fixed expenses
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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 this unit non-operating revenues and non-
operating cost are assumed to be zero. Thus, the above formula can be
restated as follows:
(P *Q)-(V*Q)-F= Profit (Net income)
where P=sales price
Q=break-even unit sales
V= variable cost per unit
F=fixed cost per period
NI= net income
At break-even point, net income = 0 because total revenue equal total expenses.
That is, NI=PQ-VQ-F
0= PQ-VQ-F……………………………………equation (1)
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 absorbs 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.
BEP= Fixed expenses
Unit contribution margin
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=PQ-VQ-F
0=Q (P-V)-F because at BEP net income equals zero.
Q (P-V) = F…divide both sides by (p-v)
Q= F ………………….…. equation (2)
P-V

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There is a variation of this method that uses the CM ratio of the unit contribution
margin. The result is the break-even point in total sales birrs rather than in total
units sold.
BEP (in sales birr) = Fixed expenses = F
CM ratio P-V
P
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.
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 is the sum of the fixed costs and the variable costs. Total
Revenue Line is line representing total sales birrs at the activity you have
selected. 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:
Total Per Percen
Unit t
Sales (20,000 units) Br. Br. 60 100
1,200,000
Variable expenses Br. 900,000 Br. 45 ?
Contribution Margin Br. 300,000 Br. 15 ?
Fixed Expenses Br. 240,000
Net Income Br. 60,000

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Based on the above data, answer the following questions.
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 point.
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 = P-V= 1-0.25 = 60 – 15 = 0.75 (75%)
P 60
b. Method 1: Equation Method
i) Net Income (NI) = PQ – VQ – FC
0 = Q (60-45) – 240,000
15Q = 240,000
Q = 240,000 =16,000 units, at Br. 60 per unit, Br. 960,000
15
ii) Let “X” be sales volume in birrs to break-even point
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
CM per unit
= Br. 240,000 = 16,000 units
Br. 60 – Br. 45
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 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 3.2.
Exhibit 3.2 Cost-Volume-Profit Chart TR
TC

Br.1,500,00

Br. 750,000 BEP

Br. 500,000
TR= Total revenues line
Br. 250,000 TC = Total costs line

0 , X
10,000 20,000 30,000 40,000

c) Increase in sales Br. 400,000

Multiply by the CM ratio X 25%

Expected increase in contribution Br. 100.000

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

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1.4 Applying CVP Analysis
1.4.1 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 (2) Zena Concepts, Inc., was found 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:
Total per Unit
Sales (400 speakers) Br.100, 000 Br.250
Variable expenses 60, 000 150
Contribution margin 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.
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 increases in the monthly advertising budget would increase
monthly sales by Br.30, 000. Should the advertising budget will be increased or
not 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
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Incremental contribution margin………………………………………… 12, 000
Change in fixed costs (incremental advertising expense)………………… 10, 000
Increased net income…………………………………………………….. Br. 2, 000
Yes, based on the information above and assuming that other factors in the
company don’t change, the advertising budget should be increased.
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 Br.90.
Expected total contribution margin (480 speakers x Br.90)……………Br.43, 200
Present total contribution margin (400 speakers xBr.100)……………. 40, 000
Increase in total contribution margin………………………………… Br.3, 200
Yes, based on the information above, the high-quality component should be used.
Since, the fixed will not change, net income will increase by the Br. 3, 200
increase in contribution margin shown above.
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?
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-speakers x 150% x Br80)
………………..Br.48, 000
Present total contribution margin (400 speakers x Br 100)………………….. 40,000
Incremental contribution margin…………………………………………….. 8,000
Change in fixed costs:
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Incremental advertising expenses………………….. 15, 000
Reduction in net income………………………………………………….. Br. (7, 000)
No, based on the information above, the changes should not be made.
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
Changes in Regular Sales Price: Refer the original data. The company has an
opportunity to make a bulk sale 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
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.
1.4.2 Target Net Profit Analysis (other than tax)
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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 (3) 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.
Required:
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 before
tax (NIBT) Br 180,000 during the year
Solution:
a. The BEP using contribution margin technique can be calculated as:
BEP (in birrs) = Fixed Expenses
CM –ratio
BEP (in birrs) =Br.180,000 + 72,000 = Br. 252,000 = Br. 630,000
20-(8+4) 0.4
20
b. Target – net profit analysis can be approached using either of these two
methods
a. Equation method
b. Contribution margin method
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:
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TI = Total sales – Variable expenses – Fixed expenses
TI = PQ – VQ – FC
Where P= sales price
Q= sales unit to achieve the targeted income
V= unit variable costs
FC = fixed costs
For Tantu Company, the targeted sales volume in units would be determined as
given below
TI = PQ – VQ – FC
180, 000 = 20Q – 12Q – 252, 000
8Q= 180, 000 + 252, 000
Thus, Q= Br.432, 000 = 54, 000 units
8
Target sales (in birrs) = Br.20 x 54,000=Br. 1, 080, 000
Alternatively computed,
Target income = PQ –VQ – FC
= Total CM* - FC
= CM-Ratio * 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
0.4S= Br.432, 000
S= Br. 432, 000 = Br.1, 080, 000
0.4
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 before tax
Unit CM
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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 (for Tantu Co.) = Fixed expenses + Target Profit before tax
Unit CM
= Br.252, 000+180, 000 =54, 000 units
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
0.4
= Br. 1, 080, 000
1.4.3. 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:
Total sales - Break even Sales = Margin of safety
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 birrs = Margin of safety Ratio
Total sales
Example (4): Consider the cost structure for ABC Company and XYZ in Exhibit
2-2

ABC Co. and XYZ Co.

Comparative Cost Structures
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 ABC Co. XYZ Co.
Amount Percen Amount Percent
t
Sales Br. Br.
500,000 100 500,000 100
Variable costs 100,00
0 20 300,000 60
Contribution Margin 400,00 200,0
0 80 00 40
Fixed costs 100,00
300,000 0
Net income Br. Br.
100,000 100,000

Required: compute BEP, margin of safety and margin of safety ratio for each
company?
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
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
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 Total sales in birrs
ABC Co.’s: Br. 125,000 = 25 %
Br.500, 000
XYZ Co.’s: Br. 250,000 = 50 %
Br.500, 000
1.4.5 Impact of Income Taxes on CVP Analysis
Thus far we have ignored income taxes. However, profit-seeking enterprises must
pay income taxes on their profits. A firm’s net income after tax, the amount of
income remaining after subtracting the firm’s income- tax expense, is less than it
is before- tax income. This fact is expressed in the following formula:
NIAT = NIBT (1 – tax rate)
Where NIAT = net income after taxes
NIBT=net income before taxes
The requirement that companies pay income taxes affects their CVP
relationships. To earn a particular after-tax net income will require greater before-
tax income than if there were no tax.
Example (5) Hydro System Engineering Associates, Inc. provides consulting
services to city water authorities. The consulting firm’s contribution margin ratio
is 20%, and its annual fixed expenses are Br. 120, 000. The firm’s income-tax
rate is 40%.
Required:
a. Calculate the firm’s break-even volume of service revenue.
b. How much before-tax income must the firm earn to make an after-tax net
income of Br. 48, 000?
c. What level of revenue for consulting services must the firm generate to earn
an after-tax income of Br.48, 000?
d. Suppose the firm’s income-tax rate rises to 45 percent. What will happen to
break-even level of consulting service revenue?

Solutions:
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a. Break-even sales= Fixed expenses
CM-ratio
= Br.120, 000
0.2 = Br. 600, 000
b. NIBT = NIAT = 48,000 = Br.80, 000
1- Tax rate 0.6
c. Target sales (in birrs) = FC + NIBT = Br.120, 000+ Br.80, 000 = Br.1, 000, 000
CM-ratio 0.2
N.B. In the formula that we have seen previously for target sales volume
computations, the target profit refers to the before- income tax.
d. BEP (in units) = Fixed expenses = FC
Unit CM P-V
BEP (in birrs) = Fixed expenses = FC =120,000 = 600,000
CM-ratio P-V 0.2
P
Thus, the change in income-tax rate has no effect on break-even sales.
1.5. CVP Analysis with Multiple Products
1.5.1 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.
1.5.2 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

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technique for firms that deal in several products. In the general case the CVP
equation could be presented as:
P1Q1 + P2Q2+...+PnQn – V1Q1 – V2Q2-...VnQn-FC = NI
Where Pi = Selling price per unit of product i
Qi = Number units of i produced and sold
Vi = Unit variable cost of product i
FC = Fixed Cost Per Period
NI = Net Income
In a multi-product firm, break-even analysis is somewhat more complex. The
reason is that different products will have different selling prices, different costs,
and different contribution margins.
Using contribution margin approach, the computation of the break-even point
(BEP) in multi-product firm follows:
BEP (in units) =Total fixed expenses
Weighted average CM
BEP (in birrs) = Total Fixed Expenses
CM – ratio
Weighted average unit contribution margin is the average of the several products’
unit contribution margins, weighted by the relative sales proportion of each
product.
For a company manufacturing and selling three products (X, Y and Z), with sales
of mix of n1,n2 and n3, respectively, the break-even point may be given by the
following short cut formula:
BEP (in units) = Total fixed costs
cm1n1 + cm2n2 + cm3n3
n 1 + n2 + n3
Where cmi = Unit contribution margin for product i.
n= sales proportion of each product
To prove the above formula, let us begin with general CVP equation for a company
producing three products.
NIBIT = P1Q1 + P2Q2 + P3Q3- V1Q1 – V2Q2 – V3Q3 – FC
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 Where, NIBT = net income before tax
Pi = Unit sales price for product i
Qi = Sales volume for product
Vi = Unit variable cost for product i
FC = Fixed cost per period
The difference between total sales and total variable costs for each product, i.e.
PiQi – ViQi, equals their total contribution margin (TCM). The above general
formula can be restated as follows:
NI = TCM1 + TCM2 + TCM3 – FC
0 = TCM1 + TCM2+ TCM3 – FC (NI equals zero at BEP)
0 = CM1Q1 + CM2Q2 + CM3Q3 – FC
Where CMi = contribution margin per unit for product i
Qi = sales volume for product i to break even
Given the sales mix X: Y: Z = n 1: n2: n3, and assuming that the company break-
even at “Q” units, then,
0 = CM1 n1Q + CM2n2Q + CM3n3 Q – FC
n 1 + n2 + n3
0 = Q(Cm1n1 + Cm2n2 + Cm3n3) – FC
n 1 + n2 + n3
FC= Q(Cm1n1 + Cm2n2 + Cm3n3)
n 1 + n2 + n3
Divided both said by

Cm1n1 + Cm2n2 + Cm3n3)

n 1 + n2 + n3
Q= FC …………….. equation (1)
Cm1n1 + Cm2n2 + Cm3n3
n 1 + n2 + n3
Here in equation (1), the denominator,
Cm1n1 + Cm2n2 + Cm3n3 , is the weighted average CM
n1 + n 2 + n 3

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Similarly, the company’s break-even sales in birrs would be calculated as
BEP (in birrs) = Fixed expenses
W ave. CM – ratio
= Fixed expenses
Average CM
Average Sales Price
= Fixed expenses
Cm1n1 + Cm2n2 + Cm3n3
n 1 + n2 + n 3

P1n1 + P2n2 + P3n3

n 1 + n2 + n 3
BEP (in birrs) = Fixed expenses …………….. equation (2)
Cm1n1 + Cm2n2 + Cm3n3
p1n1 + p2 n2 + p3n3
Here in equation (2), the denominator represents the contribution margin ratio.
Example (8) Addis Marine Products Inc. plans to manufacture and sell
accessories for recreational fishing craft and pleasure boats. Three of the
principal product lines are manufactured at the Hawassa plant. Operating data
for the coming year is estimated as follows:
Product Lines
Ethio-01 Ethio-02 Ethio-03
Sales price Br.150 Br.80 Br.40
Variable costs 100 60 10
Units sales 3, 200 units 1, 600 units 4, 800 units
The total annual fixed cost on the three-product lines amount to Br. 840,000
Required:
a) Assuming the above sales mix, determine the BEP (break-even point) for
Addis Company during the coming year. Also determine the number of
units of each product that should be sold to break even in units and in
birrs.
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 b) What volume of sales in birrs for each product must Addis Marine Products
Inc. achieve to earn a net income of Br. 73,500 after taxes in the coming
year? Assume the company is subject to a 30% income tax rate.
c) Calculate the total sales volume in units and in birrs for each product so
that Addis Company achieves 8.4% return on sales.
d) Suggest any other alternative sales mix that can lower the Company’s BEP
in units holding the unit selling price, the unit variable cost and the total
annual fixed costs constant.
Solutions:
a. BEP (in units for Addis)= Fixed Costs
Cm1n1 + Cm2n2 + Cm3n3
n 1 + n2 + n3
= Br.840, 000 = Br.840, 000
50(.33)+20(.17)+30(.5) 210
2 +1+3 6
= 24, 000 units
Product Lines BEP in units BEP in birrs
Ethio-01 24, 000 x 2/6 = 8, 000 units 8,000x150=Br.1, 200,000
Ethio-02 24, 000 x 1/6 = 4, 000 4, 000 x 80 = 320, 000
Ethio-03 24, 000 x 3/6 = 12, 000 12, 000 x 40= 480, 000
Total 24 , 000 units Br.2, 000, 000
Or computed alternatively:
Fixed expenses
BEP (in birrs for Addis) = Cm1n1 + Cm2n2 + Cm3n3
p1n1 + p2 n2 + p3n3
= Br.840, 000
50(2)+20(1)+30 (3)
150(2)+80(1)+40(3)
= Br.2, 000, 000

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b. NIAT = Br.73, 500. This implies that NIBT= = 73, 500= Br.105, 000
1-30%
Target sales (in units) =FC + NIBT = 840, 000 +105, 000 = 27, 000 units
w. Ave. CM 50(2)+20(1)+30(3)
2 +1+3
Product Lines Target sales in units Target sales in birrs
Ethio-01 27, 000 x 2/6 = 9, 000 units 9,000x150=Br.1, 350,000
Ethio-02 27, 000 x 1/6 = 4, 500 4, 500 x 80 = 360, 000
Ethio-03 27, 000 x 3/6= 13, 500 13, 500 x 40 = 540, 000
Total 27, 000 units Br. 2, 250, 000
Target Sales (in birrs for Addis) as follows;
= Fixed expenses +NIBT = Br. 840, 000 +105, 000
Cm1n1 + Cm2n2 + Cm3n3 50(2)+20(1)+30(3)
p1n1 + p2 n2 + p3n3 150(2) +80(1) + 40(3)
= Br. 945, 000
210
500
= Br.2, 250, 000
c. Total sales to achieve a target profit = Average P (Q) Where P =Sales price
Q = target sales in units
Average P= 150(2)+80(1)+40(3) =Br.500
2+1+3 6
Total sales = Average P (Q ) = 500(Q)
6
NIBT =Total sales x Return on sales
=500(Q) x 8.4% =7Q
6
Target sales (in units) = FC + NIBT = 840, 000 +7Q
Average CM 50(2)+20(1)+30(3)
2 +1+3

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 Thus, Q = 840, 000 +7Q
50(2)+20(1)+30(3)
2 +1+3
Q = 840, 000 + 7Q
210
6
210 Q =840, 000+7Q
6
210Q=6(840, 000+7Q)
210Q=5, 040, 000 + 42Q
168Q=5, 040, 000
Q= 5, 040, 000
168
Q= 30, 000 units
d. In a multiproduct company, a switch or movement from less profitable product
to more profitable product lowers break-even point in units keeping other
things, i.e., sales prices, variable costs and fixed cost per period constant. The
original sales mix was 2: 1:3 for Ethio-01, Ethio-02 and Ethio-03, respectively.
Suggested sales mix here below reduces the company’s break-even:
a) Ethio-01: Ethio-02: Ethio-03=3:1:2
b) Ethio-01: Ethio-02: Ethio-03=4:1:1
Check:
a) BEP with Ethio-01: Ethio-02: Ethio-03=3:1:2
BEP= Br.840, 000
50(3)+20(1)+30(2)
2 +1+3
=21, 913 units
b) BEP with Ethio-01: Ethio-02: Ethio-03=4:1:1
BEP= Br.840, 000
50(4)+20(1)+30(1)
2 +1+3
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 =20, 160 units
However, the suggested sales mix above may increase the company’s break-even
sales in terms of birrs.
Exercise1. Topper Sports, Inc., produces high-quality sports equipment. The
company’s Racket Division Manufactures three tennis rackets: - the Standard,
the Deluxe, and the Pro- that are widely used in amateur play. Selected
information on the rackets are given below:
Standard Deluxe Pro
Selling price per racket Br. 40.00 Br. 60.00 Br.
75.00
Variable expenses per
racket:
Production 22.00 27.00 40
Selling (5% of selling 2.00 3.00 4
price)
All sales are made through the company’s own retail outlets. The Racket Division
has the following fixed costs: Per Month
Fixed production costs………………………….Br. 120, 000
Advertising expenses…………………………… 100, 000
Administrative salaries…………………………. 50, 000
Total Br.270, 000
Sales, in units, for the month of May have been as follows:
Standard Deluxe Pro Total
Sales in units………… 2, 000 1, 000 5, 000 8, 000
Required:
a. Compute the weighted- average unit contribution margin,
assuming the above sales mix is maintained.
b. Compute the Racket Division’s break-even point in birrs for May.
c. How many units of each product should the company sale in order
to earn a Br.162, 000 incomes? Ignore income taxes.
1.6 Underlying Assumptions in CVP Analysis
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For any CVP analysis to be valid, the following important assumptions must be
reasonably satisfied within the relevant range.
1. Costs are linear (straight-line) through the entire relevant range, and
they can be accurately divided into two variable and fixed elements. This
implies the following more specific assumptions.
a. Total fixed expenses remain constant as activity changes, and
the unit variable expense remains unchanged as activity varies.
b. The efficiency and productivity of production process and
workers remain constant.
2. The behavior of total revenue is linear (straight-line). This implies that the
price of the product or service will not change as sales volume varies
within the relevant range.
3. In multiproduct companies, the sales mix remains constant over the
relevant range.
4. In manufacturing firms, inventories do not change, i.e., the inventory
levels at the beginning and end of the period are the same. This implies
that the number units produced during the period equals the number of
units sold.
5. The value of a birr received today is the same as the value of a birr
received in any future year.

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