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# PAT COLLEGE

CAT P7 – Accounting for cost Lecture Notes – Decision Making - CVP ANALYSIS 1. Cost/Volume/Profit (CVP) or Breakeven Analysis

CVP analysis or breakeven analysis is the study of the interrelationship between costs, volume and profit at various levels of activity. To help planning and decision making, management should know, not only the profit likely to be made, if the aimed for production and sales for the year are achieved, but also: • • The activity level at which there is neither profit or loss (i.e. break even point) The amount by which actual sales can fall below anticipated sales, without a loss being incurred.

2.

BREAK EVEN POINT (BEP)

The BEP is the activity level at which there is neither profit nor loss. It can be calculated arithmetically as follows:

BEP in units

=

Total Fixed Costs Unit Contribution

or

Contribution required to break even Unit Contribution

BEP in Revenue (£)

Alternatively:

=

BEP in units

X

Unit Selling Price

BEP in Revenue (£)

Where:

=

Fixed costs or Required Contribution C / S Ratio = = Selling Price – Variable cost per unit and Contribution ÷ Sales Revenue (expressed in %)

Unit Contribution C / S ratio

3.

MARGIN OF SAFETY (M.O.S.): 1

in Revenue expressed in % = Budgeted Sales Revenue (£) .O. AB Ltd.S.S.BEP in Units X 100 % Budgeted Sales Volume in units M.S.S.000 units at £8 per unit Variable Costs: Direct Materials £3 per unit Direct Labour £1 per unit Variable Overhead £1 per unit Fixed Production Costs £21.O.O. the manufacturer of Product Alpha. is the difference in units between the budgeted sales volume and the break even sales volume and is sometimes expressed as a percentage of the budgeted sales volume.S.000 Compute (i) Break even point in units and revenue (ii) Margin of safety in units and revenue Example 2: The C/S ratio of Product Alpha is 20%.BEP in Revenue (£) X 100 % Budgeted Sales Revenue (£) Example 1: Expected Sales 10. wishes to to make a contribution of £50. Budgeted fixed costs are £70.000 units. How many units of Preoduct Alpha must be sold if the selling price is £10 per unit? Example 3: Homer Ltd makes and sells a product which has a variable costs of £30 and which sells for £40.O. in units expressed in % = Budgeted Sales Volume (units) .The M. M. BREAK EVEN ARITHMETIC 2 .000 towards fixed costs.000 and budgeted sales are 80. in units M. Compute (i) Break even point in units and revenue (ii) Margin of safety in units and revenue 4. in Revenue (£) = = Budgeted Sales Volume (units) Budgeted Sales Revenue (£) - BEP in Units BEP in Revenue (£) M.O.

e.000 units.000 per annum. Required: If fixed costs are £63. i. SR S (x) S (x) Where x S F V = = = = = = = TC Fixed Costs F + + Variable Costs V (x) the sales quantity Unit Selling Price Total Fixed Costs Unit Variable Costs Target Profits (P): The target profit is achieved when: S (x) S (x) = = Therefore Fixed Costs F S (x) + + Variable Costs V (x) V (x) = + F + + Target Profits P P Example: 4 Upminister Ltd makes a product. calculate the selling price per unit if the company wishes to break even with a sales volume of 12. sales revenue (SR) equals total costs (TC) and there is no profit.At breakeven point. for which variable costs are as follows: Direct Materials £ 10 Direct Labour 8 Variable Production Overhead 6 24 The sales price is £30 per unit and fixed cost per annum are £68. Required: Determined the sales required to achieve this profit. The company wishes to make a profit of £16. 3 .000 per annum. Example 5: Whoopee Ltd makes and sells a single product. which has a variable cost of £7 per unit.000.

(b) Suppose that there is a fixed demand for Bangs and Crashes of 1. These problems are slight variations on basic breakeven arithmetic. Required Ascertain the minimum volume of sales required each month to justify a rise in price to 29p.000 units of each product and the minimum sales demand is 1. EXAMPLE 6: CHANGE IN SELLING PRICE Fairy Ltd bakes and sells a single type of cake. Bang Crash Wallop Selling price per unit £80 £50 £70 Variable cost per unit £50 £10 £20 Fixed costs per month = £160.000 The maximum sales demand per month is 2.000. Required (a) Comment on the potential profitability of the company. Required Calculate the sales price per unit. Bang. Fixed costs are £47. Example 7: Grumpy Ltd wishes to sell 14.000 of each.600 per month. The sales manager wishes to raise the sales price to 29p per cake.000 and the required profit is £23. and the annual profit for the Company at current sales volume is £36. EXAMPLE 8: TARGET PROFITS Flash Ltd makes and sells three products.5. but considers that a price rise will result in some loss of sales. variable Cost per unit or fixed Cost. The variable Cost of production is l5p and the Current sales price is 25p. Crash and Wallop. The selling price per unit and costs are as follows. 4 . which has a variable cost of £15 to make and sell.000 units of its product. Fixed Costs are £2.500 units per month. DECISIONS TO CHANGE SALES PRICE OR COSTS You may come across a problem in which you will be expected to analyse the effect of altering the selling price.000. The volume of sales demand is constant throughout the year.

A breakeven chart is a chart. Required (a) Determine the number of units that must be produced and sold to achieve the same profit as is currently earned. but for which firm orders have been received. and the current volume of output and sales is 6.Ends at the point which represents the following: Anticipated sales on the horizontal axis Total costs of anticipated sales on the vertical axis 5 .which will not be exceeded. A breakeven chart has the following axes: • • A horizontal axis showing the sales/output (in value or units). Determine how many Wallops would have to be sold to achieve a profit of at least £25.Runs parallel to the horizontal axis . the sales price per unit is £18. if the machine is hired. which shows approximate levels of profit or loss at different sales volume levels within a limited range.Starts at the origin .000 per annum. EXAMPLE 9 : CHANGE IN PRODUCTION COSTS Brick Ltd makes a product which has a variable production cost of £8 and a variable Sales cost of £2 per unit.000 per month. Fixed costs are £40.000 and it is expected that the variable cost of production would fall to £6 per unit. 6. The company is considering whether to have an improved machine for production.Starts where the fixed costs line meets the vertical axis . • • BREAKEVEN CHARTS The breakeven point can also be determined graphically using a breakeven chart.000 units per annum. A vertical axis showing £ for sales revenues and costs The following lines are drawn on the break-even chart: The sales line: .Meets the vertical axis at a point which represents total fixed costs The total costs line: .000 units. (b) Calculate the annual profit with the machine if output and sales remain at 6.Ends at the point signifying expected sales The fixed costs line: . Annual hire costs would be £10.

6. and the variable cost per unit will also eventually rise where diseconomies of scale begin to appear at higher volumes of output (for example the extra cost of labour in overtime working). Example 11: Use the information in example 10 above to draw a P/V chart. in units.Fixed costs will change if output falls or increases substantially .The variable cost per unit will decrease where economies of scale are made at higher output volumes. The distance between the breakeven point and the expected (or budgeted) sales.000 and the variable costs are 50p per unit. This is a simplification. The fixed overheads amount to £40.most fixed costs are step costs . The sales price is £1 per unit. indicates the margin of safety. Required Construct a breakeven chart showing the current breakeven point and profit earned up to the present maximum capacity. . 6. EXAMPLE 10: A BREAKEVEN CHART The budgeted annual output of a factory is 120.• • The breakeven point is the intersection of the sales line and the total costs line. It is assumed that fixed costs are the same in total and variable costs are the same per unit at all levels of output.3 THE ADVANTAGES AND LIMITATIONS OF CVP ANALYSIS Limitations of CVP analysis • • A breakeven chart can only apply to one single product or a single mix (fixed proportions) of a group of products. 6 .1 THE VALUE OF BREAKEVEN CHARTS Breakeven charts are used as follows: • • • 6.000 units.2 To plan the production of a company’s product To market a company’s products To give a visual display of break even analysis PROFIT VOLUME CHARTS The profit volume (P/V) chart is a variation of the breakeven chart which provides a simple illustration of the interrelationship of costs and profits to sales.

This may not be true. where the price may have to be reduced to win the extra sales. Uncertainty in the estimates of fixed costs and unit variable costs is often ignored in breakeven analysis. 7 . especially at higher volumes of output. therefore the consequences of any increase in stock levels (when production volumes exceed sales) or 'de-stocking' (when sales volumes exceed production levels) are ignored. • • The advantages of CVP analysis In spite of limitations.A breakeven chart is drawn on the assumption that fixed costs and the variable cost per unit is constant. this is only correct within the relevant range of output. Breakeven analysis should be used with a full awareness of its limitations. but can usefully be applied to provide simple and quick estimates of breakeven volumes or profitability given variations in sales price. • It is assumed that sales prices will be constant at all levels of activity. the desired sales mix. variable and fixed costs within a 'relevant range' of output/sales volumes. and profitability. and some costs (for example mixed costs and step costs) are not always easily categorized or divided into fixed and variable. Production and sales are assumed to be the same. breakeven analysis is a useful technique for managers in planning sales prices.