Cost-volume-profit analysis

Introduction
• Decision making process involves selecting
from a range of possible courses of action.
• Before making a decision, managers need to
compare the likely effects of the options they
are considering.
• This discussion looks at one technique that
allows managers to consider the
consequences of particular courses of action
and is known as Cost-Volume-Profit (CVP)
analysis.
Introduction
• CVP analysis examines the relationship between
changes in activity (e.g. output) and changes in total
sales revenue, costs and net profit.
• It allows for prediction of what happens to financial
results if a specified level of activity or volume
fluctuates.
• Knowledge of this relationship enables
management to identify critical output levels, such
as the level at which neither profits nor loss will
occur known as the break-even point.
Introduction
• CVP analysis highlights the effects of
changes in sales volume on the level of profit
in the short run i.e one year or less, a time at
which output of the firm is restricted by the
available capacity.
• During this period some inputs such as
supply of labour and raw materials can be
varied at short notice, but operating capacity
cannot be significantly changed.
Introduction
• For example it is not possible to expand
hospital facilities to increase the number of
beds or for a hotel to increase the number of
rooms in the short run.
• The term volume within CVP analysis has
multiple meanings, however, units of output
or activity, tend to be the most widely used
terms. For some organisations determining
the units of output is straight forward.
Introduction

• For instance, for a car manufacturer the

amount of output will be the number of cars
produced and for a computer manufacturer it
will simply be the number of computers
produced.
• Service organisations, however, face a more
difficult choice. Hotels may define units in
terms of the number of guest nights, leisure
centres may use the number of visitors and
airlines might use the number of passenger
Curvilinear cost-volume graph

1. Results in two break-even points.

2. Note the shape of the total cost function:
• initial steep rise, levels off, followed by a further steep rise.
3. The total revenue line initially rises steeply, then levels off and declines.
 Curvilinear CVP Relationships
• Above diagram showing CVP behaviour
• The total revenue and total cost lines are curvilinear
• The total revenue line (0-C) initially resembles a
straight line but then begins to rise steeply and
eventually starts to decline because the firm can
only increase sales quantities by reducing the unit
price.
• The decline occurs because the adverse effects of
price reductions outweighs the benefits of increased
sales volume.
 Curvilinear CVP Relationships
• The total cost line (A-D) illustrates cost behaviour in
a manufacturing firm but similar cost behaviours
applies in non-manufacturing firms.
• Between A and B, total costs rise steeply at first as
firms operates at lower level of volume range
(underutilisation of capacity).
• Between B and C, the total cost line initially levels
out and rise less steeply as the firm operates the
facility at efficient range taking advantage of
economies of scale (i.e. specialisation of labour and
smooth production schedules).
 Curvilinear CVP Relationships
• Economists describe this situation as increasing
returns to scale
• On the upper part of the volume range the total cost
line between C and D rises more steeply as the cost
per unit increases due to:
 Manufacturing facilities being operated beyond their
capacity
 Bottlenecks develop, production schedules become
more complex and equipment breakdowns begin to
occur.
Curvilinear CVP Relationships

 Overall effect is that cost per unit of output

increases and causes the total cost line to rise
steeply. Economics describe this situation has
decreasing returns to scale.
Linear CVP relationships
Linear CVP relationships
Linear cost–volume–profit model
•From the above diagram, the total cost line X-Y and
the total revenue line 0-V assume that variable cost
and selling price are constant per unit of output.
•The results is that there is a linear relationship (i.e. a
straight line) for total revenue and total cost as output/
volume changes.
•The two straight lines results in only one break-even
point
•The profit area widens as volume increases.
Linear CVP relationships

Summary
• Constant variable cost and selling price is assumed.

• Only one break-even point, and profit increases as volume

increases.

• The diagram is not intended to provide an accurate

representation for all levels of output. The objective is to
provide an accurate representation of cost and revenue
behaviour only within the relevant range of output.
 Relevant Range
• The objective of linear relationships is to represent
the behaviour of total cost and revenue over a range
of output at which a firm expects to be operating
within a short-term planning horizon.
• The range of output is represented by the output
range between points Q1 and Q2 in the linear cost-
volume-profit model.
• Q1 and Q2 represents relevant range, that is the
output levels that the firm had experience of
operating in the past and for which information is
available.
Relevant Range

• Within this range the cost and revenue relationships

are more linear and not outside the range.

 CVP analysis should therefore only be applied within

the relevant range. If the relevant range changes,
different fixed and variable costs and selling prices
must be used.
Fixed cost function
• Within the short term the firm anticipates that it will
operate between output levels Q1 and Q2 and commits itself to fixed
costs of 0X.

• Costs are fixed in the short term, but can be changed in the longer
term.
A Numerical Approach to Cost-
Volume-Profit Analysis
Example 1
Lee Enterprises operates in the leisure and entertainment
industry and one of its activities is to promote concerts at
locations throughout the world. The company is examining
the viability of a concert in Singapore. Estimated fixed costs
are £60 000, these include the fees paid to performers, the
hire of venue and advertising costs. Variable costs consists
of the cost of a pre-packed buffet that will be provided by a
firm of caterers at a price, which is currently being
negotiated, but it is likely to be in the region of £10 per
ticket sold. The proposed price for the sale of the ticket is
£20.
A Numerical Approach to Cost-
Volume-Profit Analysis
Required
The management of Lee have requested the following
information:
1.The number of tickets that must be sold to break-even (that is,
the point at which there is neither a profit nor a loss).
2.How many tickets must be sold to earn £30 000 target profit?
3.What profit would result if 8000 tickets were sold?
4.What selling price would have to be charged to give a profit of
£30 000 on sales of 8000 tickets, fixed costs of £60 000 and
variable costs of £10 per ticket?
A Numerical Approach to Cost-
Volume-Profit Analysis

5. How many additional tickets must be to cover the extra

cost of television advertising of £8000?
6. The margin of safety (by how much sales must decrease
before a loss occurs).
Solution
CVP analysis: non-graphical computations
Example 1
Fixed costs per annum £60 000
Unit selling price £20
Unit variable cost £10
Relevant range 4 000 - 12 000 units

1. Break-even point
Fixed costs = £60 000/£10 = 6 000 tickets Contribution
per ticket

2. Units to be sold to obtain a £30 000 profit:

Fixed costs + desired profit = £90 000/£10 = 9 000 tickets
Contribution per tickets
4. If unit fixed costs and revenues are not given, the break-even point (expressed in
sales values) can be calculated as follows:

Total fixed costs x Total sales = £120 000

Total contribution

5. Profit volume ratio = Contribution x 100 = 50%

Sales revenue

6. Percentage margin of safety =

Expected sales - Break-even sales = 25% for £160 000 sales
Expected sales
Break-even chart for Example 1
CONSTRUCTING THE BREAKEN-EVEN
CHART

• Managers may obtain a clearer understanding of

CVP behaviour if the information is presented in a
graphical format.
• Using example one we can construct the break-even
chart.
• Activities/output is plotted on the horizontal axis.
• Monetary amounts for total costs, total revenues
and total profits (or loss) are recorded on the
vertical axis.
CONSTRUCTING THE BREAKEN-EVEN
CHART

• In example one the fixed costs are plotted as a

single horizontal line at the £60,000 level.
• Variable costs at the rate of £10 per unit of volume
of output are added to the fixed costs to enable the
total cost line to be plotted. Two points are required
to insert the total cost line.
• The total revenue line is plotted at the rate of £20
per unit of volume. At zero output total sales are
zero and at 12,000 units total sales revenue is £240,
000.
CONSTRUCTING THE BREAKEN-EVEN
CHART

• The total revenue for these two points are plotted on

the graph and a straight line is drawn that joins these
points.
• The point at which the total sales revenue line cuts
the total cost line is the point where the concert
makes neither a profit nor a loss. This is the break-
even point and is 6000 tickets or £120,000 total
sales revenue.
 ALTERNATIVE PRESENTATION OF
COST-VOLUME-PROFIT ANALYSIS

Contribution Graph
•An alternative to the break-even chart is the
contribution chart below.
•The variable cost line is drawn starting from zero
output at the rate of £10 per unit of volume.
•Fixed costs are presented by the difference between
total cost line and the variable cost line.
•Fixed costs are assumed to be constant throughout
the entire output range.
ALTERNATIVE PRESENTATION OF
COST-VOLUME-PROFIT ANALYSIS

• A constant sum of £60,000 for fixed costs is added

to the variable cost line, which results in the total
cost line being drawn parallel to the variable cost
line.
 The advantage of this form of presentation is that it
emphasizes the total contribution, which is
presented by the total sales revenue line and the
total variable cost line.
Contribution chart for Example 1
ALTERNATIVE PRESENTATION OF
COST-VOLUME-PROFIT ANALYSIS

Profit – Volume Graph

•Neither the break-even nor the contribution graphs
highlight the profit or loss at different volume levels.
•To ascertain the profit or loss figures from a break-
even graph, it is necessary to determine the difference
between the total cost and total revenue.
•The profit-volume graph is a more convenient method
of showing the impact of changes in volume on profit
as shown below.
Profit-volume graph for Example 1
ALTERNATIVE PRESENTATION OF
COST-VOLUME-PROFIT ANALYSIS

The steps for construction of profit graph are:

1.Select a scale for sales on X-axis (horizontal). The
sales line divides the graph into two parts. One part
reveals profit and the other loss.
2.Select a scale for fixed costs, profit or loss on the
(vertical) Y-axis. The fixed costs and loss are shown
below the sales line on the left hand side of the
vertical line and profit is shown above the sales line on
the right hand side of the vertical line.
ALTERNATIVE PRESENTATION OF
COST-VOLUME-PROFIT ANALYSIS

3. Plot the fixed costs and profits of corresponding

sales and join them to get the profit line. The profit
line is a diagonal line which cuts the sales line
at breakeven point.
CVP analysis assumptions

1. All other variables remain constant

• e.g.sales mix, production efficiency, price levels, production methods.

2. A single product or constant sales mix

3. Total costs and total revenues are linear functions of output

4. The analysis applies only to the relevant range.

5. The analysis applies only to a short-term horizon.

Example

Product X Product Y
Unit contribution £12 £8
Budgeted sales mix 50% 50%
Actual sales mix 25% 75%

Fixed costs are £180 000

Budgeted BEP = £180 000 /£10 (a) = £18 000 units

Actual BEP = £180 000 /£9 (b) = 20 000 units

(a) (50% × £12) + (50% × £8)

(b) (25% × £12) + (75% × £8)