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COST-VOLUME-PROFIT RELATIONSHIPS

LEARNING OBJECTIVES

2. Break even point analysis

3. Managing leverage and cost structure

4. Weaknesses of cost-profit-volume analysis

INTRODUCTION

concerned with analyzing the relationship between changes in output and changes in total sales

revenue, expenses and net profit. Manager are constantly faced with decisions about selling

prices, sales volume, sales mix and costs (variable and fixed) in order to find the right

combination of these four factors that will produce satisfactory profits. Moreover, a graphical

approach provides a useful representation of how costs, revenues and profits will behave for the

many possible output levels.

The objective of CVP analysis is to establish what will happen to the financial results if a

specified level of activity fluctuates.

The study of CVP is often called break-even analysis. The break-even point is the point when

total revenue and total costs are equal. In other words, at this point there is no net income or loss.

Both the variable and fixed costs are covered by sales revenue at the break-even point. The break-

even point represents a target of minimum sales volume that the manager must achieve because it

does indicate the level of sales necessary to avoid a loss.

Below is a very simple example to show various analytical techniques used in CVP analysis.

BIB Bhd. owned by Adura plans to rent an MBSA store. She is analyzing an average selling price

of RM 50 and average cost price of RM 30 per unit of book item. She targeted to sell 2000 units

of book items at the following costs:

Rent RM10,000

Wages of helpers RM 8,000

Other fixed costs RM 2,000

Total RM 20,000

1

There are THREE approaches to determine break-even point:

1. Contribution Margin Approach

2. Equation Approach

3. Graphical Method

By using this approach, each book item sells for RM 50, but RM 30 of this is used to

cover variable costs. This leaves RM 20 (RM 50 – RM 30) per unit of book item to

contribute to covering the fixed costs of RM 20,000. When enough book items have been

sold in one month, RM 20 contributions per food item add up to RM 20,000 then, Puan

Adura will break even.

CONTRIBUTION MARGIN PER UNIT

= RM 20,000

RM 20

= 1,000 units

Puan Adura must sell 1,000 units of book items per month in order to break even.

The calculation of break-even also can be computed in sales dollar instead of units. The

contribution to sales ratio is expressed as a percentage. Interpretation of the higher ratio

means the contribution grows more quickly as sales level increase.

From the above illustration, C/S ratio can be used to calculate break-even point as

follows:

SALES

= RM 20 X 100

RM 50

= 40%

C/S RATIO

= RM 20,000

40%

= RM 50,000

2

2. Equation Approach

This approach is based on the profit equation. Profit can be calculated as follows:

SALES VOLUME IN UNITS) – FIXED COSTS

To find break-even for a month for Puan Adura, it is assumed that profit is zero.

RM 20X = RM 20,000

X = 1,000 UNITS

equation approach have two equivalent techniques.

COST-VOLUME-PROFIT RELATIONSHIP

Direct labour xxx

Direct expenses xxx

Fixed cost xxx

Profit/loss xxx

Alternatively, profit figure can be computed as follows which is known as Marginal Cost

Statement

(a) Contribution is the amount remaining from sales revenue after variable expenses have

been deducted.

Sales XXX

Less: Variable Cost XXX

Less : Fixed Cost XXX

Profit/Loss 3 XXX

Formula in CVP Analysis:

or

Profit/Volume RATIO (P/V RATIO)

Sales

(OR)

Sales

Selling Price Per Unit

(OR)

Change in Sales

There are basically three types of graphs that can be used, namely :

b) Contribution break-even graph

c) Profit – Volume graph

Total

Fixed

Sales Sales Total V.C Total Costs Profit /

Costs

(Loss)

(Units) (RM) (RM) (RM) (RM) (RM)

500 2500 1500 2000 3500 (1000)

1000 5000 3000 2000 5000 0

1500 7500 4500 2000 6500 1000

2000 10000 6000 2000 8000 2000

4

a) Traditional break – even graph

5

ASSUMPTIONS/LIMITATIONS OF CVP ANALYSIS

1. The unit sales prices remain constant throughout the period being considered.

2. All costs can be easily identified as being either variable or fixed with a reasonable amount of

accuracy.

3. Variable costs will change in total amount proportionately with volume.

4. Total fixed costs will remain constant over the entire range of activity being considered.

5. Single or constant sales mix

6. Total costs and total revenue are linear functions of output. Total cost and total revenue

change proportionately to changes in volume.

7. Risk and uncertainty are ignored and perfect knowledge of cost and revenue functions is

assumed.

8. It is assumed that the firm is a price taker, i.e. a perfect market is deemed to exist.

9. The efficiency and productivity of the production and workers remain constant.

CONCLUSIONS

b. Variable Costs Is Constant Per Unit

c. Selling Price Is Constant Per Unit

d. All Costs Can Be Resolved Into Fixed And Variable Costs

e. Efficiency and productivity are to be unchanged

a. A fixed cost is fixed only within a given time span and over a given range of activity.

However, it may change from budget year to budget year when the activity level changes too

greatly.

b. Variable costs per unit is assumed to be constant. However, variable costs may fall as

volume increases and trade discounts or economies of large scale are achieved, and will then

rise when the demand for resources exceed supply.

c. Selling price may be reduced to achieve greater volume of sales.

d. In practice it is not always feasible to resolve all costs into their fixed and variable

elements.

e. Efficiency and productivity to change, thus affecting costs.

f. Volume, though important, it not the only factor affecting costs. Factors such as

efficiency, productivity, war, government legislation also affects costs.

The above assumptions act as major limitations of the CVP analysis, but nevertheless it is a

powerful tool for decision making in the short run.

6

Self Review Questions

4. What information other than break-even point can be obtained by managers from a

CVP graph?

ii) Break even analysis

iii) Margin of safety

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