COST VOLUME

PROFIT ANALYSIS
(CVP)
FACILITATOR: MR GREGORY ADEN
CVP
• Variable cost varies directly with the volume of production or
output. On the other hand, fixed cost remains unaltered
within the relevant range. Thus, if volume is changed,
variable cost will vary in proportion to the volume. In this
case, selling price remains fixed, fixed cost remains fixed
which translates to a change in profit. Managers constantly
strive to relate these elements in order to achieve maximum
profit. Apart from profit projection, the concept of Cost-
Volume-Profit (CVP) is relevant to virtually all decision making
areas, particularly in the short run.
Continued
• Profit depends on a large number of factors, most important
of which are the cost of manufacturing and the volume of
sales. Both these factors are interdependent. Volume of sales
depends upon the volume of production and market forces
which in turn is related to costs. Management has no control
over market. In order to achieve certain level of profitability,
it has to exercise control and management of costs, mainly
variable cost. This is because fixed cost is a non-controllable
cost and is irrelevant for decision making where it is not
changed by the course of action taken.
Continued..
The key factor here is cost related, which may be
determined by various factors
• Material prices, wage rates and overhead costs may all change
because of the impact of inflation
• Material usage may change where scrap is expected to fall
because of improved methods, better trained workers or better
material quality.
• Labor efficiency may change where improved training
programs or a reduction in labour turn over is expected to
occur.
Continued…
• Internal efficiency and the productivity of the factors of
production; Overhead expenses may fall due to more
efficient placement of order with suppliers who offer best
terms
• Product volume of production or size of batches.
• Product mix may change either as part of overall company
strategy or due to increased competition.
• Methods of production and technology.
• Size of plant.
Continued
• Thus, one can say that cost-volume-profit analysis furnishes
the complete picture of the profit structure. This enables
management to distinguish among the effect of sales,
fluctuations in volume and the results of changes in price of
product/services. Simply CVP is a management accounting
tool that expresses relationship among sale volume, cost and
profit. CVP can be used in the form of a graph or an equation.
OR involves the determination of either of the variables (cost,
profit or volume) given a relevant set of data. This includes
the price per unit, cost per unit, fixed cost, and profit .
Assumptions on CVP
a) Volume is the only factor affecting sales and expenses
The changes in the level of various revenue and costs
arise only because of the changes in the volume of
output produced and sold.
b) Total costs can be divided into fixed and variable
components. Variable component will vary directly with
level of output. Direct materials, direct labour and direct
chargeable expenses form the direct variable costs while
variable part of factory overheads, administration
overheads and selling and distribution overheads form
the variable overheads.
Assumptions on CVP
c) There is linear relationship between revenue and cost.
d) The behavior of both sales revenue and expenses is linear
throughout the entire relevant range of activity. Graphically, it
assumes a linear equation of the form Y=mX + C
e) The unit selling price, unit variable costs and fixed costs are
constant.
f) The theory of CVP is based upon the production of a single
product. However, of late, management accountants are
functioning to give a theoretical and a practical approach to
multi-product CVP analysis.
Assumptions on CVP
g) There is only one product or service or a constant Sales Mix.
The analysis either covers a single product or assumes that the
sales mix sold in case of multiple products will remain constant
as the level of total units sold changes.
h) All revenue and cost can be added and compared without
taking into account the time value of money.
i) Theory of CVP is based on the technology that remains
constant.
j) Theory of price elasticity is not taken into consideration.
k) Inventories do not change significantly from period to period
CVP analysis
• Cost and revenue equations
From the marginal cost statements, the following equations can
be derived:
Sales – Marginal cost = Contribution……………… (1)
Contribution – Fixed costs = Profit
∴Fixed cost + Profit = Contribution…………… (2)
From the above equations, we get the fundamental marginal cost
equation as follows:
Sales – Marginal cost = Fixed cost + Profit ………. (3)
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Rearranging the equation above to make profit the subject of
the formula one will get
Profit = Sales – Marginal cost – Fixed cost………. (4)
Let the selling Price be S, Marginal cost per unit (variable
cost per Unit) be V, Profit be P, level of output be x and fixed
costs be F We have seen that sales and Marginal cost vary
directly with output
From equation (4) above we obtain
Profit P = (Selling Price S – Variable cost V)output x – Fixed
cost F
P= (S-V)x -F
Example
• Assume the following situation:
Selling price per Unit Shs.2,000
Direct material unit cost Shs.600
Direct labor unit cost Shs.300
Variable manufacturing overhead Shs.200
Variable marketing Shs.250
Fixed manufacturing overhead Shs.500,000
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Calculate the level of profits in the following independent situations.
a) The level of output 1000 units
b) The level of output is 750 units
c) The price falls to Shs.1900 and the level of output produced is
1,500.
d) Direct material unit cost falls to Shs.500, selling price falls to
Shs.1900 and the output produced rises to 1750 units
BREAK EVEN POINT AND ANALYSIS
Break-even analysis and CVP analysis are one and the same thing. The
only distinction is that CVP analysis targets to establish the relationship
between the volume of output, the cost incurred and revenue received
while Break-even analysis aims at establishing the minimum output that a
firm must produce and sell in order to remain in business. If a firm
operates below that level of activity, it makes a loss. Break-even analysis
is built on CVP analysis principles.
Break-even point is the volume of sales where there is neither profit nor
loss. At this point revenues and total costs are equal. For every unit sold
in excess of the break-even point, profit will increase by the amount of
the contribution per unit. All the variable costs and fixed costs are
covered by the sales revenue.
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At Break-even point, BEP,
Total revenue = Total costs Profit
P=0
Contribution – Fixed costs = 0
Contribution = Fixed cost
Mathematical determination of Break-even
point
From the definition of break-even point, At Break-even point,
Total revenue = Total costs and therefore, profit is equal to
zero. i.e. from the fundamental marginal equation, CM⋅x = F +
P, Hence
Contribution (CM⋅x) – Fixed costs, F = 0
since Profit is equal to zero. Upon making contribution the
subject of the formula,
Contribution (CM⋅x) = Fixed cost (F)
CM⋅x = F
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To obtain break-even point in units, make x (output) the
subject of the formula by dividing both sides of the equation
by Contribution margin per unit.
Sale, Xbep = Fixed Costs/ CMor(P-V)
Note that this formula is identical to the CVP one except for
the profit, which in this case is zero. This brings out clearly
the idea that break-even analysis and cost volume profit
analysis are one and the same thing. In fact, the terms are
at times used interchangeably.
The graphical approach
Continue

• Graph above display the relationship of cost to volume and profits and
show profit or loss at any sales volume within a relevant range.
(Assumption; fixed costs do not change)
Example
• ABC produces and sells Product X at Shs.500. The
Unit manufacturing cost of X is Shs.200 and total
fixed manufacturing costs equal to Shs.300,000. The
company incurs selling and administration costs
equal to 2% of sales revenue and fixed selling cost of
Shs.100,000 per annum.
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a) Determine the break-even sales in units and in shillings
b) Determine the units that should be sold to earn a net
income of Shs.200,000
c) If the company was in the 30% tax bracket, how many
units will have to be produced to earn the Shs.200,000
d) Management is considering a policy which would
increase fixed manufacturing costs by shs.200,000 but
cut down on the variable manufacturing cost by 20%
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i. What is the break-even point in units and in revenue
under this policy?
ii. Assuming the 30% tax bracket, how many units will
have to be produced to earn the target profit of
Shs.200,000 under this new policy?
e) At what level of sales level will management be
indifferent between the two policies?
f) Assuming that the maximum possible demand is 6,000
units, determine the range of sales which will be
financially beneficial in each policy.
MARGIN OF SAFETY
This is the excess of budgeted sales over the break-even volume
in sales. It states the extent to which sales can drop before
losses begin to be incurred in a firm
Margin of safety is a tool designed to point out a problem but not
to solve it. To rectify the problem of a low MOS, management
must direct its efforts towards either reducing the break-even
point or increasing the overall level of sales. Margin of safety
indicates by how much sales may decrease before a loss occurs
MOS is calculates as:
MOS = Total budgeted sales – Break-even sales
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MOS may also be expressed as a percentage of sales. The
higher the percentage, the better positioned a firm is in its
operations.
MOS%= (MOS in Shillings/Total sales)* 100
= (Expected sales- break even sales)/Expected sales
*100
Example
• Pentagon Ltd gives the following financial information about its
product, calculate margin of safety
Fixed cost 9,000,000
Variable cost 15,000,000
Sales 30,000,000
Unit sold 10,000
Calculate the contribution margin ratio (P/V)
in single and multi-product situations
• Contribution to sales ratio (C/S ratio) ratio is also termed profit-volume
ratio (P/V ratio). Usually the contribution to the sales ratio is expressed as a
percentage. The contribution to the sales ratio remains constant if the
selling price and variable cost of an organization remain constant
• Calculation of contribution to sales ratio, Under single product scenario
• Contribution to sales ratio = Total contribution x 100
Sales value
= (Sales - Variable costs) x 100
Sales value
Under multi-product scenario
• Under the multi-product scenario, weighted average contribution margin is
derived by multiplying the product‘s contribution ratio with the proportion
of the product in total sales.
• Weighted average contribution margin (WACM) = (C/S ratio of product 1 x
Proportion of product 1 in total sales) + (C/S ratio of product 2 x Proportion
of product 2 in total sales) x ……. x (C/S ratio of product n x Proportion of
product n in total sales)
• Break-even point (in terms of units) = Fixed Costs
Weighted average contribution margin per
unit
Break-even point (in terms of sales revenue) = Fixed cost
Weighted average contribution margin
ratio
Example
• The Smiles Curvature Store produces two products, lipsticks and lip-
gloss. These account for 40% and 60% of the total sales of the company
respectively. Variable costs (as a percentage of sales) are 40% for
lipsticks and 50% for lip-gloss. Total fixed costs are TZS540 million
Example
• Blackberry Plc has given the following details about its cost structure, The
sales price of its sole product is $22,000 per unit and the fixed costs per
annum are $85 million. During the period, 18,000 units of the product
were produced and sold. With the help of information given by Blackberry
Plc. calculate the C/S ratio Amount “000”
Direct material 8
Direct labor 4
Variable overhead 3