16 Cost-volume- profit (CVP) analysis Outcomes At the end of this chapter students should be able to describe cost-volume-profit analysis + calculate breakeven point Chapter outline 16.1 Introduction 16.1.1 Fixed costs 16.1.2 Variable costs 16.1.3 Marginal costing layout use cost-volume-profit analysis to estimate profits calculate and evaluate the effect of changes in selling prices, voluy volume and 16.4 Cont, Using CVP analysis in decision making 16.4.1 Change in the seling price 16.2 Assumptions of CVP analysis 16.42 Change in the variable 16.3 CVP according to the contribu- cost tion margin approach 16.3.1 Calculation of breakeven 16.4.3 Change in the fixed cos: Summary of formulae needed point for CVP analysis 16.3.2 Calculation of margin of 16.5.1 Breakeven pointin units safety 16.5.2 Breakeven pointin rand: 16.3.3 Sales required to achieve expected (target) profit or return 16.1 Introduction Cost-volume-profit (CVP) analysis is @ decision-making management determine the effects that cl anges in costs, price, qu@ 16.5.3 Sales necessary to makes desired profit 16.5.4 Margin of safety hat hel too! p analyss use CV! mix will have on future profits. Managers commonly tool to answer questions such as the following: sil incur 10sses” «How much can sales drop before the company will in fits? i i ume affect pro * How will a change in costs, pnce or volt rot d * How many units must be sold to achieve | * What profit will a certain sales volume yie! al? come equ! © At what volume of production are costs and in!COST-VOLUME-PROFIT (CVM) AMAL a were introduced to the marginal income statement where “_ ple costs are shown separately. Management requires sr nina format that promotes their planning, control and deci- ks. These tasks can best be performed when information on able cost components are available. vot 19° ond varial d costs ya Fixe / 4 are costs that do not change in total with different production «og costs ? is for example rent on premises. wel, ! 16.1.2 variable costs costs that change in total with different production levels, unit basis; that is, the variable cost per unit f the changes in the production levels, for ple costs are put remain constant on a per- will remain constant irrespective 0 example raw materials. varia 16.1.3 Marginal costing layout Marginal costing layout of an income statement R sales (10 000 units x R5) 50 000 Less: Variable costs (10 000 units x R2) 20 000 Contribution margin/marginal income 30 000 Less: Fixed costs 20 000 10 000 Net profit Note 1: When using the marginal costing layout, total costs have been divided into fixed and variable costs. Note 2: Sales - Variable costs = Contribution (This is the contribution towards paying fixed costs and making a profit.) profit once all expenses have been cov- A business will only begin making @ (that is, cost price of the goods) must ered. This means that variable expenses be covered by the selling price of the goods. Any profits on the sale of goods must then contribute towards the payment of the fixed costs. Once these fixed costs have been covered, it can be said that the business has broken even and so can begin making @ profit. 16.2 Assumptions of CVP analysis g are a few basic assumptions that CVP analysis is based on: The followin: « The selling price will remain constant, irrespective of the | ‘All costs can be divided into fixed and variable components. evel of activity. Yan Sonat Onana NON-ACCOUNTANT COUNTING FO! acc¢ ain constant, irrespective of the volume. will rem Variable e proportion to the volume. e Cox, « Fixed costs WI ' will change 10 direct according to the contribution margin approach 16.3 CVP " ‘VP analysis will be illustrated by means of the following example: CVP ani Budgeted income statement of Toys Ltd, a manufacturer of Product Diy judg. m 7 OO Total Cost per unit l= cuesqooowi) | __R#00 000 bt Sales (10 000 units) oe Rao | 0 Less: Variable costs (10 000 units) R300 000 R30 i R100 000 -— Contribution margin/marginal income RIO : x cost R40 000 i Less: Fixed costs [~ Net profit R60 000 The contribution margin is the amount remaining after variable Costs have been deducted from sales revenue. It is first used to cover fixed Costs and then contributes to the profit for the period. If the contribution Margin is not sufficient to cover fixed costs, then there will be a loss. The contribution margin can also be shown on a unit basis, which is calcu. lated as follows: Contribution margin per unit = Selling price - Variable cost per unit = R40- R30 =R10 The contribution margin expressed as a percentage is known as the contribu: ton margin ratio, which is the difference between the sales and the variable Cost, expressed as a percentage of sales. Unit amounts or total amounts can be used in the calculation of this ratio Contribution margin ratio = (Sales - Variable costs) + Sales x 100 = (R400 000 - R300 000) = R400 000 x 100 = 25% or ; 00 = (SP per unit - Vc per unit) + SP per unit* ' = (R40 ~ R30) = R40 x 100 = 25% A higher contribution margii Tapidly as the sales level: Passed, profits will accu Contribution Margin rati eS - a ition increas in ratio means that the contribution ne beet S increase. Once the breakeven point lowe! mulate more rapidly than a product 10.COST-VOLUME-PROFIT (cvP) aNaLYsis 16 c jeulation of breakeven point + - 163° keven point, total revenue equals total Costs and profit is equal to ne brew nuribution is equal to fixed costs, . 5 At this point, co 400 000 7— Variable cost Fixed cost 2000 4000 6000 8000 10 000 Units: Figure 16.4 Illustration of breakeven point using a breakeven graph BREAKEVEN QUANTITY Breakeven quantity is the number of units that must be sold so as to recover all fixed Costs, that is, the point at which no profit or loss is incurred. Breakeven quantity = Fixed costs + Contribution margin per unit = R40 000 = R10 = 4000 units Breakeven value is the equivalent of breakeven quantity expressed in rands; that is, the Sales revenue necessary to recover all costs. Breakeven value = Breakeven quantity x Selling price = 4000 units x R40 = R160 000 oF 293 | Breakeven value = Fixed costs + Contribution margin ratio u = R40 000 = 25% u = R160 000a COUNTANTS ACCOUNTING FOR NON- ACCOUNT: The breakeven value can also be used to calculate the breakeve, "qua Breakeven quantity = Breakeven value = Selling price anti, R160 000 + R40 = 4000 units 16.3.2 Calculation of margin of safety The margin of safety represents the amount by which the Sales ey breakeven sales It an indication of the amount by which sere before any losses are sustained. It can be calculated and expressed ate, rand value or as a percentage iis MARGIN OF SAFETY EXPRESSED AS A VALUE = Total sales - Breakeven sales = R400 000 ~ R160 000 = R240 000 or = Profit + Contribution margin ratio = 60000 = 25% = R240 000 MARGIN OF SAFETY EXPRESSED IN UNITS = Total sales (units) - Breakeven sales (units) = 10 000 units - 4.000 units = 6 000 units MARGIN OF SAFETY RATIO (EXPRESSED AS A PERCENTAGE) _ Total sales - Breakeven sales Total sales value * 200 _ R240.000 ~ R400 000 * 100 = 60% or _ Total sales (units) - Breakeven sal les (units) Total sales units 200. 6 = £000 10.000 * 100 = 60% ash iinet This indicates that sales can decrease by 60% before the company “" a loss.COST-VOLUME-PROFIT (ovP) ANALYSIS 18 quired to achieve expected (target) Profit or return jes re niques, the sales value or volume that will produce a certain giso be determined Using the illustrative example, suppose 6 ced profit of R30 000 is anticipated from the sales of product sal 164 eve tech jusTRATIVE EXAMPLE i _culaton wil Be as flows: Fixed costs + Target profit gales volume (units) = Cor trbution margin per unit R40 000 + R30 000 ~ R10 = 7000 units = Sales volume x Selling price per unit = 7.000 units x R40 per unit = R280 000 or sales value _ Fixed costs + Target profit ~ Contribution margin ratio _ R40 000 + R30 000 Sales value 0,25 = R280 000 Proof a Total | Sales 7 000 units x R40) R280 000 Less Vanable costs (7 000 units x R30) R210 000 Combtonmagn nro000 | | less Fired costs ee R40 000 | Target profit. = R30 000 | Note: The above two formulae used to calculate sales volume and value are adjust- Ments to the breakeven quantity and breakeven value formulae. That Is, if sales volume is fequired, then the breakeven quantity formula is adjusted by adding target profit to — Costs and, similarly, if the sales value is required, then the breakeven value formula is adjusted by adding target profit to fixed costs. 295 16.4 Using CVP analysis in decision making ii , i i likely to re 5 This technique reveals the effect management decisions are likely to hav 8 dict the res: ©n the future profit structure. It enables management (o pre sults — |= 296 ONbinton COUNTING FOR NON. ACCOUNTANTS of decisions An analysis of the breakeven point enables effective steps and to influence the variable factors in, We will now examine the effect of changes in pri profits, contribution and the breakeven point. Mana, em a pu nt ee, Posef uly " CO8ts oy ' "ge a} hy These figures will be used to discuss the different factors yy. on the following illustrative examples Which hap Sales units 20 000 Reig Sales pnce per unit R15 Vanable costs per unit RO Contribution margin per unit R6 Contribution margin ratio 40% Total fixed costs for the period R60 000 Breakeven value (BEV) R150 000 Breakeven quantity (BEQ) 10 000 units 16.4.1 Change in the selling price Changes in the selling price alter the contribution ratio, ch al even point and affect profit nge the brea, ILLUSTRATIVE EXAMPLE Assume an increase of 10% in the selling price to achieve a target profit of R30 000 Required Calculate the following 1 Contribution margin ratio 2 Breakeven point in units and rand 3. Number of units that must be sold to achieve the target profit Round off to the nearest whole number. Solution Current After price increase Selling price per unit R15,00 16,50 Variable costs 9,00 fam Contribution marain 6,00 R750 Contribution ratio 40% 45% 2750 BEQ = Fixed costs = Contribution per unit = R60000 + RE = R60 a : = 10.000 units = 8.000 <0 16: BEV = BEQ x sp = x18 = 8.000 10.000 x 1 = 3082 000 = R150000- COST-voLUs, ME-p ROFIT (cvp) a NALYSIS 16 cer ol units to achieve the target Profit ” Current Atter egcosts + Target profit = 780.000 + R30 099 R60 Price increase _ FT gution margin per unit eee 52.000 + 30 000 “can = 15.000 units 7.50 1 ; j i ‘ven point are lower. the contribution margin 1@ breakeven Point climbs 'sses below the breakeven = 12.000 units ; ed and other costs remaj ne selling price Is increas main constant, the conty ; ey and the fixed costs can be recovered faster, thus the breakeven Se sa cons ond the breakeven point are higher and losses below the break ee ne selling Price Is decreased and other costs remain constant, is ower and the rate of fixed cost recovery is slower, thus th ’ ypvards. Profits beyond the breakeven point are lower and Io: point are higher. 16.4.2 Change in the variable cost Like changes in the selling price, increases an n ’ id decreases in the variable cost alter the contribution ratio, change the breakeven point and affect Profits. ILLUSTRATIVE EXAMPLE 7 7 Assume an increase of 20% in variable cost due to i increases in the material prices. The company needs to achieve a target profit of R30 000 Required Calculate the following: 1. Contribution margin ratio 2. Breakeven point in units and rand 3. Number of units that must be sold to achieve the target profit Round off the nearest whole number. Solution Current After price increase 15,00 15,00 Selling price per unit x isa Variable costs Contribution margin 28% 40% Contribution ratio co 000 -paza jt = REO 000 = RE = + RAJ BEQ = Fixed costs + Contribution per unit’ =1 = 14 286 units 7 +028 ion ratio. = 60.000 = 0,40 = 60.000 = 0,2 BEV = Fixed costs + Contribution ratio = R150 000 = R214 286 297 jeve the target profit 5 its to achieve 3 nk msoonn Roe _ neon + mevoce ff Fixed costs + Target prot _ - RE i o = Contribution margin per unit = 15 000 units = 21-429 unitsaccountants cto ounTinG FoR NON ne same effect as @ decrease in the sey ell of fixed cost recovery IS slower, thus Pes t! le costs Nas " nd tl baer he breakeven point are lower, the ‘losses pg,” al von ierense 0 Ye Er ng te i a margin iS [0 contort imbs nighet Profits after t! over nigher. yen point are breake’ van tw able CO 1 decrease IO YEN igher and I the rea, Ore, game effect as an increase in the seij a fixed eli rate of fixed cost recovery is scoala Price contribution mar fits beyond the breakeven point are hi . breakeven Pont ops pe m st me . breakeven point 76 low’ = in the fixed cost 16.4.3 Change d decreases i do change n the fixed cost do not alter the contribut;, on, the breakeven point. Marg, j Increases a” ratio, but they ILLUSTRATIVE EXAMPLE — — me an increase ‘of R10 000 in fixed costs. Assul Required Calculate the following: 1 Contribution margin ratio 2. Breakeven point in units and rand 3. Number of units that must be sold to achieve the target profit Round off to the nearest whole number. Solution c 7 econo aad After price increase Variable costs Rs f oi Contribution margin pa BEQ = : ‘buti Fixed costs = Contribution per unit = R60 000 + R6 = R70 000 = R6 = 10000 units - n swe = 11 667 units ixed costs + Contribution ratio = 60 000 + 0,40 70.000 = 0.40 +0, = 70000 = 04 = R150 000 = RI75.000 Numbe it er of units to achieve the target profit _ Fixed costs + = Ge costs + Target profit 000 R6O 000 + R30 000 70 000 + ROM Coniiban ‘ontribution margin per unit RE R6 - ‘ 29g |" tixed costs are increased. spon cna ont 52) Ap dec y the amount of the “ay assis Efe ee - . Tease in fixed . Costs ; ee e (oy ven point Cause: are smaller by the aeons bee the breakeven point to drop. Prove peor’ AMOUN ofthe domes Hoerease: losses pelow the break ase.ce TVOLUME-PROE!T (c ary of formulae needed for Cvp analysis mm sul : 6 even point in units real 1651 Fixed costs a - Variable cost p/u) rice p/u = gelling P even units = Breakeven rands = Selling Price prea 5,2 Breakeven point in rands 16: , you need to calculate the contribution Margin ratio prstly. J TRIBUTION MARGIN RATIO. sales - Variable costs « 100 7 Sales pREAKEVEN POINT IN RANDS Fixed costs : ~ Contribution Margin ratio or Breakeven rands = Breakeven units x Selling price 16.5.3 Sales necessary to make a desired Profit Add the Tequired/target profit to the fixed costs in either of the breakeven formulae: it i Fixed costs + Required profit Sal nits = = eat may ‘rest profit (Selling price p/u— Variable Cost p/u) i i Required profit Sales in rands to make target profit = Fixed costs + Required profit Sosts + Required pr Contribution margin ratio 16.5.4 Margin of safety MARGIN OF SAFETY AS a PERCENTAGE = Bu ‘geted sales ~ Breakeven sales 100 Budgeted sales MARGIN OF SAFETY IN RANDS = Budgeted sales - Breakeven sales or = Profit = Contribution margin ratio MARGIN OF SAFETY IN UNITS = Budgeted sales in units - Breakeven sales in units 16oO BASIC ACCOUNTING FOR NON-ACC JUNTANTS yw close the business is operating to its bre; This shows i the business only just breaking even OF doe other words, breathing space? "TUTORIAL EX J se ERCI a a : Exercise 1 For each of the multiple-choice questions that follow, se} ‘or lect the Most prate answer. Pre Questions 1.1-1.5 are based on the following information: XYZ Ltd manufactures and sells a single product, The costs and rhe this product are presented below: Ne Oo | Total S | I Per ng | Sales 15 000 units) R750 000 | Foo Less: Variable expenses R360 000 I Rag Contnbution margin R380 doo Rae Less’ Fixed expenses Ri69000 | aoa P89 00 Net prof 21000 { -——___ 1.1 Whatis the company’s contribut a 52% b. 25% Cc. 35% d. 53% ‘tion Margin ratio? 1.2 Whatis the com @. 5600 units b. 6500 units © 2500 units 4. $200 units Whatis the company’s breakeven Point in rand? @ R523 000 db. R35, 000 c d pany's breakeven Point in units? 13 R325 000 R253 000