ACCOUNTING/FINANCE
SAMPLE TEXT AND EXAM QUESTION

Cost-Volume-Profit Analysis

CVP analysis is used to analyze the factors that affect a firm’s profitability.  It examines the relationship between sales, expenses, and net income. 

An income statement based on financial accounting concepts would look like this:

This income statement format emphasizes product expenses (cost of goods sold) and period expenses which are the costs that the company incurred during the accounting period that were not directly related to the product that was being sold.  Period expenses are often referred to as selling, general and administrative expenses (SG&A) and include items such as the accounting staff, the cost of their office equipment, and the office building.

From management’s perspective, a more useful way of looking at that information in an income statement might look like this:

This alternative approach is based on the same activity as the first income statement.  Notice that sales, total expenses and net income are the same in the two income statement formats.  The alternative approach breaks expenses into two categories based on the behavior of the cost item.  Variable costs are those that change in direct proportion with the level of sales.  In total, variable costs fluctuate based on the level of sales.  However, because variable costs increase directly with increases in sales, the resulting variable cost per unit remains the same.  A cost is considered a fixed cost if it remains the same when sales levels change.  Because fixed costs do not change even when sales fluctuate, on a per unit basis the cost per unit declines as sales increase.  This is a result of dividing a constant dollar amount by an increasing number of units, which drives down the cost per unit. 

QUESTION:

The LeeAnn Family Restaurant is open 24 hours a day and serves breakfast, lunch, and dinner.  The owner of the business has determined that fixed costs are $24,000 per month.  Variable costs are estimated at $9.60 per meal.  The average total bill (excluding tax and tip) is $12 per customer.

1. Compute the break-even point in meals.
2. Compute the break-even volume in dollars.
3. Compute the number of meals that must be served if the LeeAnn Family Restaurant wishes to earn a profit of $6,000.
4. Assume that fixed costs increase to $30,000.  How many additional meals must be served if the restaurant wishes to earn the same profit?

ANSWER:

1. To breakeven, the restaurant will need to serve 10,000 meals.

2. The breakeven volume in dollars is $120,000.  Given that the breakeven point in meals is 10,000 each meal has an average price of $12, then sales needed to breakeven would be $120,000 (10,000 x $12).

3. To earn a profit of $6,000 the restaurant will need to serve 12,500 meals. 

4. To continue earning $6,000 when the fixed costs have increased to $30,000, the restaurant will need to serve 15,000 meals (computations shown below).  The question actually asks how many “additional” meals will need to be served so the answer is 2,500 meals which is the difference between the 12,500 meals now needed and the prior amount of 10,000.

Another way to determine the number of additional meals needed is to divide the $6,000 increase in fixed costs by the $2.40 contribution margin per unit.  That computation directly indicates that the restaurant would need to serve an additional 2,500 meals.