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ACF 360
MANAGEMENT ACCOUNTING
LESSON 3
CVP Analysis
It is more relevant where the proposed changes in activity are relatively small so
that established cost patterns and relationships are likely to hold good.
With greater changes in activity and over the longer term, existing cost
structures, e.g. the amount of fixed cost and the marginal cost per unit, are likely
to change so C-V-P analysis is unlikely to produce useful guidance.
Typical short run decisions where CVP analysis may be useful include:
choice of sales mix, pricing policies, multi-shift working and special order
acceptance.
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CVP ANALYSIS ASSUMPTIONS
The major assumptions behind CVP analysis must be stated. These are:
All costs can be resolved into fixed and variable elements. Fixed costs will remain
constant and variable costs vary proportionately with activity. Over the activity
range being considered costs and revenues behave in a linear fashion. That the
only factor affecting costs and revenues in volume. That technology, production
methods and efficiency remain unchanged. Particularly for graphical methods,
that the analysis relates to one product only. There are no stock level changes or
that stocks are valued at marginal cost only. There is assumed to be no
uncertainty.
It will be apparent that these are over simplifying assumptions for most practical
situations so that CVP analysis should be used with caution and only as an
approximate guide for decision making.
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CVP ANALYSIS BY FORMULA
CVP analysis can be undertaken by graphical means or by simple formulae as follows:
Break-even point (in units)
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
=
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛/𝑢𝑛𝑖𝑡
1
= 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠×
𝐶/𝑆 𝑅𝑎𝑡𝑖𝑜
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Level of sales to result in target profit (in Units)
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠+𝑇𝑎𝑟𝑔𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
=
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛/𝑢𝑛𝑖𝑡
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EXAMPLE
Calculate
• Number of units to break even
• Sales at break-even point
• C/S ratio
• What number of units will need to be sold to achieve a profit of GHȻ20,000
• What level of sales will achieve a profit of GHȻ20,000 p.a
• As (d) with a 40% tax rate.
• Because of increasing costs the marginal cost is expected to rise to GHȻ6.50
per unit and fixed costs to GHȻ70,000 p.a. If the selling price cannot be
increased what will be the number of units to maintain a profit of
GHȻ20,000 p.a. (ignore tax)
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SOLUTION
Working:
Contribution =𝒔𝒆𝒍𝒍𝒊𝒏𝒈 𝒑𝒓𝒊𝒄𝒆 −𝒎𝒂𝒓𝒈𝒊𝒏𝒂𝒍 𝒄𝒐𝒔𝒕
=𝑮𝑯Ȼ𝟏𝟎−𝑮𝑯Ȼ𝟔
=𝑮𝑯Ȼ𝟒
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SOLUTION
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Total units=15,000+5,000=20,000×GHȻ10=GHȻ200,000
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GRAPHICAL APPROACH
This may be preferred:
• Where a simple overview is sufficient
• Where there is a need to avoid a detailed, numerical approach
when, for example, the recipients of the information have no
accounting background.
The basic chart is known as Break Even Chart which can be drawn in
two. The first is known as the traditional approach and the second
as the contribution approach. Whatever approach is adopted, all
costs must be capable of separation into fixed and variable
elements, i.e semi-fixed or semi-variable costs must be analyzed
into their components.
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THE TRADITIONAL BREAK-EVEN CHART
Assuming that fixed and variable costs have been resolved, the chart is drawn in the
following way:
a)Draw the axes
Horizontal: showing levels of activity expression as units of output or as percentages of
total capacity.
Vertical: showing values of GHȻ’s or GHȻ000s as appropriate for costs and revenues.
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Example 7
A company makes a single product with a total capacity
of GHȻ400,000 litres p.a. Cost of sales data are as
follows:
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SOLUTION
It can be seen that break-even point is at an output level of 200,000 litres and that the width of the profit wedge
indicates the profit at a production level of 300,000. The profit is GHȻ50,000.
***** Note: “The margin of safety” indicated on the chart is the term given to the difference between the activity level
selection and break-even point. In this case the margin of safety is 100,000 litres.
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THE CONTRIBUTION BREAK-EVEN CHART
This uses the same axes and data as the traditional chart. The only difference being that variable
costs are drawn on the chart before fixed costs resulting in the contribution being shown as a wedge.
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AN ALTERNATIVE FORM OF THE CONTRIBUTION BREAK-EVEN CHART
An alternative form of the contribution break-even chart is where the net difference
between sales and variable cost, ie total contribution is plotted against fixed costs.
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PROFIT CHART
.
This is another form of presentation with the emphasis on the
effect on profit of varying levels of activity. It is a simpler form of
chart to those illustrated so far because only a contribution line is
drawn.
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PROFIT CHART
Note : Lines for variable and fixed costs and sales do not appear, merely the one summary
profit line.
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CHANGES IN COSTS AND REVENUES
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PROFIT CHART SHOWING CHANGES IN FIXED COST
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PROFIT CHART SHOWING CHANGES IN CONTIBUTION
RATIO
The above figure shows the effect of variable cost and/or price changes which have a
net effect on contribution. If, say, an increase in variable costs was exactly
counterbalanced by an increase in sales price, the contribution would be the same and
the original profit line would still be correct.
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BREAKEVEN ANALYSIS WHERE THERE ARE
MULTIPLE PRODUCTS
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Example
The current selling price for three hot drinks sold by a coffee
house are GH₵3, GH₵3.5 and GH₵4 for This Way Chocolate drink,
Lipton tea and Nescafe respectively. In a year, 50% of the total
revenue was generated from the sales of This Way, 30% from
Lipton and 20% from Nescafe whiles variable cost was 50p, 60p
and 70p respectively. If fixed cost was GH₵55,000…
Calculate the break even point in units for the coffee house.
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SOLUTION
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SOLUTION
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LIMITATIONS OF BREAK-EVEN AND PROFIT CHARTS
The charts may be reasonable pointers to performance within normal activity ranges, say 70% -
120% of average production. Outside this relevant range, the relationship depicted almost
certainly will not be correct. Although it is conventional to draw the lines starting from zero
activity, relationships at the extremes of activity cannot be relied upon. A typical range of activity
could be shown as follows
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The various charts depicted show cost, volume and profit relationships in a simplified and
approximate manner. They can be useful aids, but whenever they are used the following
limitations should not be forgotten
1. Variable costs and sales are unlikely to be linear. Extra discounts, overtime payments, the effect of
the learning curve, special price contracts and other similar matters make it likely that the
variable cost and revenue lines are some form of curve rather than a straight line
2. The charts depict relationships which are essentially short term. This makes them inappropriate
where the time scale spans several years.
3. CVP analysis, like marginal costing, makes the assumption that changes in the level of output are
the sole determinant of cost and revenue changes. This is likely to be a gross over-
simplification in practice although volume changes, of course, do have a significant effect on
costs and revenues. )
4. It is assumed that there is a single product or a constant mix of products or a constant rate of
mark-up on marginal cost and revenues.
5. Risk and uncertainty are ignored and perfect knowledge of cost and revenue functions is
assumed.
6. It is assumed that the firm is a price taker, i.e. a perfect market is deemed to exist.
7. It is assumed that revenues and all forms of variable cost (materials, labour and all the
components of variable overheads) vary in accordance with the same activity indicator. This is an
oversimplification in most realistic situations.
8. Fixed costs are likely to change at different activity levels. A stepped fixed cost line is probably the
most accurate representation
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i) ALTERNATIVE FORMS OF BREAK-EVEN CHARTS
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STEPPED LINEAR COST FUNCTION WITH LINEAR REVENUE
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STEPPED LINEAR REVENUE FUNCTION WITH LINEAR
SEMI VARIABLE COST
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NON LINEAR REVENUE FUNCTION AND MULTIPLE BREAKEVEN
POINTS
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ECONOMISTS VIEW OF CVP ANALYSIS
Economists believe that costs and revenues are not linear but
curved therefore, given the objective of profit maximization, the
optimal activity level is where marginal cost equals marginal
revenue.
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ECONOMISTS’ BREAK EVEN CHART
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ECONOMIST VIEW OF OPTIMAL PROFIT
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OPTIMIZING THE LEVEL OF ACTIVITY
Where the cost and or revenue functions are non linear,
then it is possible to determine the optimal level of activity
in accordance with objectives of the firm. This can be done
in two ways, either by drawing graphs of the functions or by
using employing calculus.
It will be recalled that the process of differentiation
provides a ready means of finding the rates of change of
non-linear functions and of their turning points.
If the non-linear functions represent cost and revenue then
the rates of change are marginal cost and marginal revenue
respectively and the turning point of the functions are the
points of minimum cost and maximum revenue
respectively.
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EXAMPLE
A firm has the following cost and revenue functions
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END OF LECTURE
THANK YOU!
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