INTRODUCTION

COST-VOLUME-PROFIT ANALYSIS

A cost-volume-profit (CVP) analysis is a systematic method of examining the effects of changes in an

organization’s volume of activity on its costs, revenue and profit. It is useful for the management in
knowing how profit is influenced by sales volume, sales price, variable expenses and fixed expenses.

Break-even point

Break-even point is the level of sales at which profit is zero. According to this definition, at break-even
point sales are equal to fixed cost-plus variable cost. This concept is further explained by the following
equation:

[Break even sales = fixed cost + variable cost]

The break-even point can be calculated using either the equation method or contribution method.
These two methods are equivalent.

Contribution

Contribution margin is a measure of operating leverage: the higher the contribution margin is (the lower
variable costs are as a percentage of total costs), faster the profits increase with sales. In the linear CVP
analysis Model, contribution margin is a fixed quantity, and does not change with Sales. Contribution =
Sales - Variable Cost

Margin of Safety

The margin of safety is a tool to help management understand how far sales could change before the
company would have a net loss. It is computed by subtracting breakeven sales from budgeted or
forecasted sales. To state the margin of safety as a percent, the difference is divided by budgeted sales.
Margin of safety is the difference between the intrinsic value of a stock and its market price.

In Breakeven analysis margin of safety is how much output or sales level can fall before a business
reaches its breakeven point.

Applications

1. CVP simplifies the computation of breakeven point in break-even analysis.

2. Allows simple computation of Target Income Sales.
3. It simplifies analysis of short run trade-offs in operational decisions.

Limitations

a) Profit Maximization--cost-volume-profit relationship is not a profit maximization technique

because it does not place any limitations upon the number of units a business can produce and
sell.
b) Multiple Products--cost-volume-profit relationship requires simplifying assumptions to apply it
to a business that manufactures more than one product
COST-VOLUME-PROFIT ANALYSIS

A cost-volume-profit (CVP) analysis is a systematic method of examining the effects of changes in an

organization’s volume of activity on its costs, revenue and profit. It is useful for the management in
knowing how profit is influenced by sales volume, sales price, variable expenses and fixed expenses.

A critical part of CVP analysis is the point where total revenues equal total costs (both fixed and variable
costs). At this breakeven point (BEP), a company will experience no income or loss. This BEP can be an
initial examination that precedes more detailed CVP analysis.

Cost-volume-profit (CVP) analysis is a technique that examines changes in profits in response to changes
in sales volumes, costs, and prices. Accountants often perform CVP analysis to plan future levels of
operating activity and provide information about:

 Which products or services to emphasize.

 The volume of sales needed to achieve a targeted level of profit.
 The amount of revenue required to avoid losses.
 Whether to increase fixed costs.
 How much to budget for discretionary expenditures?
 Whether fixed costs expose the organization to an unacceptable level of risk.

Cost-Volume-Profit Relationship

A. Cost Classification
(1) Variable Costs--variable costs are those costs that vary proportionately with changes in
the level of activity (such as direct materials, direct labor, salesmen’s commissions, etc.)
(a) Relevant Range--even though variable cost per unit may vary throughout the entire
range of possible activity, the variable cost per unit is assumed to remain constant
over the range of activity over which the business expects to operate.
(2) Fixed Costs--fixed costs are those costs that do not change with changes in the level of
activity (such as depreciation, property taxes, executive salaries, etc.)
(a) Relevant Range-even though fixed costs may vary throughout the entire range of
possible activity, fixed costs are assumed to remain constant over the range of
activity over which the business expects to operate
(3) Mixed Costs--mixed costs are those costs that have both a variable and a fixed
component (such as utility costs, costs of operating a truck, etc.)
(a) Allocation--mixed costs must be classified into variable and fixed components for
cost-volume-profit relationship purposes
B. Formula Approach
1) Derivation
a) Units--the net income of a business can be described by the following equation
SP x U – VC x U – FC = NI

Where,

SP = selling price per unit

U = number of units sold
VC = variable cost per unit
 FC = fixed costs
NI = net income
Factoring out the common term, units, from the first two terms in the equation results in the
following equation.

U x (SP – VC) – FC = NI

Adding fixed costs to both sides of the equation results in the following equation.

U x (SP – VC) = NI + FC

Dividing both sides of the equation by (SP – VC) results in the following equation.

U = (NI + FC) / (SP – VC)

Assumptions of Cost-Volume-Profit Analysis.

1) All costs can be analyzed into their fixed and variable elements. When we talk about fixed and
variable costs, we usually assume that it is possible to take a look at individual or total costs and split
them into their fixed and variable elements.

However, if we look at any organization of a reasonably large size we will quickly appreciate that not
only might there be several hundred costs comprising total cost but also there are many forces acting on
those costs (cost drivers in activity based costing parlance). Consequently, it cannot be a simple matter
of a few minutes' analysis and the fixed and variable split has been fully explained.

Splitting out fixed and variable costs can be a long, time-consuming process; and techniques such as the
inspection of accounts method really are not suitable if the analysis is to be realistic. At the very least,
some kind of statistical or mathematical analysis will have to be undertaken. I have undertaken this kind
of an exercise in a wide variety of companies and industries; and it takes many man hours to research
the organization, set up and work a spread sheet, analyze the results and then present my findings.

This is not to suggest that the splitting of fixed and variable costs is too difficult for the average student
or practitioner. Consider diagram one below (which we can assume for the sake of the discussion is the
regression line derived from an analysis of a business's total costs) and suggest the level of fixed costs
and hence calculate a variable cost per unit:

The graph is suggesting a regression equation of:

y = a + bx = 1,000 + 3x

Which, in the present context, will be interpreted as: the fixed cost for the business is Tk1,000; and the
variable cost per unit is Tk3.

It should be remembered that this graph refers to the whole business and, as we have already agreed, a
reasonably large business is complex: consequently, although a statistical analysis can be carried out, its
results will not always be as simple to interpret as the assumptions on which CVP analysis, and the
example surrounding diagram one, would have us believe.

Imagine the problems which must be faced by the analyst trying to cope with the kind of cost portrayed
in diagram five: no longer a straight line at all; and such cost profiles are likely to be the normal: as
opposed to straight lines, that is.
More than all of this, though: it is frequently the case that even the people working in an organization
will have little or no idea

a) Of their fixed/variable cost split; and

b) How to split their total costs into their fixed and variable components if asked!

It is these two aspects that often cause management accountants to assume linearity and/or spend
many hours analyzing total costs.

Assessing the fixed and variable cost split can be fraught with difficulties and can be time consuming.

2) Fixed costs remain fixed even over a wide range of activity.

Another simplifying assumption which helps to keep the arithmetic of CVP analysis simple but which
does not help those of us who wish to apply the techniques. The common view of fixed costs is given in
diagram two:

However, the major error contained in such charts is that it ignores (or merely assumes away) the
importance of the relevant range.

The relevant range is the range of levels of activity over which the business has direct experience. That
is, it has probably produced at or over that range of outputs; or it has studied such levels of output
carefully. Hence, no business will know with certainty what its fixed costs will be outside its relevant
range; and there is no guarantee that fixed costs will remain fixed if the business produces at a level of
output outside its relevant range: whether through expansion or contraction. Diagram three illustrates a
more realistic scenario: where a fixed cost can change as a result of a change in output level to a level
outside the relevant range. The relevant range in diagram three is represented as 401 units to 800 units.

The reasons why fixed costs will change in such a way include, for a reduction in output: managers and
supervisors being laid off as no longer required at reduced levels of output; machinery sold; buildings
sold or not rented any more. A similar analysis applies to an increase in output and fixed costs.
Fixed costs behaving in this step cost fashion is another cause for concern over glibly trying to apply CVP
analysis. We may not, in fact, know how our fixed costs will behave outside our relevant range unless
and until we carry out detailed cost analysis of extra relevant range scenarios.

3) Variable costs always vary directly with activity.

It is possible for a cost to be truly variable and behave in a perfectly linear way: think of examples such
as making one standard design of wooden tables and chairs. However, it is still useful to explore here
the more likely exceptions to that behavior.

Diagram four demonstrates how a perfectly variable cost behaves:

In reality, of course, a whole host of forces can act upon a cost which is deemed to be variable. For
example, once a business grows beyond a certain size it can then enjoy the benefits of greater volume:
such benefits are known as economies of scale and include being awarded trade discounts, being
offered cash discounts now that it can obtain credit; and quantity discounts because it can now buy in
greater bulk. Consequently, even though the quantity of components in a product remains standard and
fixed, their cost per unit can fall as a result of these economies of scale.

These changes to the basic assumption of linearity mean that when diagram four shows a perfectly
straight line, reality could be more like diagram five where we can easily be dealing with a situation
where variable costs are essentially variable but which are not perfectly variable. In the case of diagram
five, we see a true curve; and any analysis of an estimation of a precise relationship between variable
cost and output will yield a solution but not a linear one. Again, since any reasonably large business will
have many such costs, isolating the variability of all such costs can be a major task.

There are many variations on the possible shapes which a variable cost curve might assume. For
example, it might be the case that at higher levels of output a variable cost curve starts to slope
upwards again, having initially behaved like the curve in diagram five: such a situation would hold when
diseconomies of scale or increasing import tariffs were being imposed.

4) Selling prices are constant per unit.

A very similar series of arguments holds for selling prices as held for variable costs. There is no reason
why any business needs to sell to all of its customers at the same price for all products. We could easily
demonstrate that different prices are offered for different levels of purchasing: for example, discounts
for bulk buying. The hypothesis of supply and demand also dictates that the higher the price the fewer
will be sold; and the lower the price the more will be sold. Diagram six combines the basic assumed sales
curve and a more realistic sales curve based on the arguments just put forward.

Again, when we consider the realistic side of total sales a true curve emerges; and again, this means that
any analysis of sales immediately becomes more difficult than the basic assumptions of CVP analysis
would have us believe.
As with the variable cost curve, there are potentially many shapes which the sales curve could take on:
diagram six gives only one variation from the usually assumed straight line.

5) Only levels of activity affect costs and revenues

This, to some extent, is the worst of all of the assumptions from the point of view of a realistic
application of CVP analysis. It is the worst because it denies there being such things as labor efficiency
and changes to labor efficiency: the learning effect is ignored, or assumed away, by this assumption, of
course.

Along with all of the discussion so far, there are many reasons why a total cost or a cost per unit might
change; and changes in the level of output is only one. Consider your own environment: why might any
one of the costs with which you are associated change? In the case of a manufacturer, costs might
change because someone has improved the way an operation is performed. A friend of mine, John, has
a good eye for helping people to work more efficiently. One day he Noticed that an operative in a
factory was working on making components for a Poly Tunnel (greenhouse type thing!) and was working
on a bench but keeping his metal rods on the floor. John brought a stand around to where the operative
was working and put the metal rods on there … the operative then completed his jobs in half the time it
used to take! The consequences of this relate to time, productivity, possibly better-quality output and
the cost per unit will have improved. None of the reason for this change in cost is due to the restrictive
assumption of output being the only determinant of cost.
Concepts of Cost Accountancy used in COST-VOLUME-PROFIT Analysis

Before starting with explanation of Cost Volume Profit Analysis, we would like to briefly explain a few
basic concepts which are important while understanding CVP analysis.

Fixed Cost

These costs remain fixed in ‘total’ and do not increase or decrease when the volume of production
increases or decreases.

But the fixed cost ‘per unit’ increases when the volume of production decreases and decreases when the
volume of production increases.

Fixed cost per unit cannot be zero.

Examples – Rent, Insurance

Variable Cost

These costs fluctuate in proportion to the volume of production. In other words when volume of output
increases total variable cost also increases and when volume of output decreases the variable cost also
decreases.

But the variable cost ‘per unit’ remains fixed.

Example – Direct Material cost, direct wages

Direct Cost

These are the costs which are incurred for and can be conveniently identified with, a particular product,
process or department.

Example- cost of leather in manufacturing a pair of shoes.

Indirect Cost

These are general costs and are incurred for the benefits of a number of cost units, processes or
departments. These costs cannot be conveniently identified with a particular product.

Example – Power, Insurance

Total Revenue

Total revenue is the total money received from the sale of any given quantity of output. The total
revenue is calculated as the selling price of the firm's product times the quantity sold, i.e.

Total revenue = Price × Quantity

Total costs

Total cost is the sum of fixed costs, variable costs, and semi-variable costs. In other words it can also be
explained as the sum of the Direct Cost plus the Indirect Cost.

Cost center
A location, a person or an item of equipment (or group of these) for which costs may be ascertained and
used for purpose of cost control

Cost unit

A unit of product, service or time in relation to which costs may be ascertained or expressed

Sales mix

The term sale mix refers to the relative proportion in which a company's products are sold. The concept
is to achieve the combination that will yield the greatest number of profits. Most companies have many
products, and often these products are not equally profitable. Hence, profits will depend to some extent
on the company's sales mix. Profits will be greater if high margin rather than low margin items make up
a relatively large proportion of total sales.

Selling Price per Unit

The amount of money charged to the customer for each unit of a product or service.

Target Profit

Target profit is the amount of net operating income or profit that management desires to achieve at the
end of a business period. Management needs to know the required level of business activities to get
target profits. Cost volume profit (CVP) equations and formulas can be used to determine the sales
volume needed to achieve a target profit. The two methods of doing so are-

 Equation Method

Sales = Variable expenses + Fixed expenses + Profits

 Contribution Margin Method:

[(Fixed expenses + Target profit) / Contribution margin per unit]

BREAK-EVEN POINT ANALYSIS

Break-even point is the point at which the gains equal the losses. A break-even point defines when an
investment will generate a positive return. The point when sales or revenue equal expenses or also the
point where the total cost equals the total revenue. There is no profit made or loss incurred at the
break-even point. This is important for anyone that manages a business, since the break-even point is
the lower limit of profit when prices are set and margins are determined. Therefore, the break-even
point is that quantity of output where the

total revenue =total cost i.e. the operating income is zero

Break-even point is calculated by the following methods:

 Equation Method
 Contribution margin method
 Graphical method
1. Equation Method:

The income statement can be expressed in equation form as follows:

Revenues-Variable Costs-Fixed Costs= Operating Income

The equation provides the most general approach to any CVP situation.

Let N be the No. of units sold to break even, Let P be the price at which the units are sold, VC be the cost
of the product (product related expense) and FC be the cost for the product not directly related to the
product.

Setting Operating income= 0 we have;

N*P-VC*N-FC=0

Therefore, N=FC/ (P-VC)

If the company sells fewer than FC/ (P-VC) units of commodity, it will make a loss. If it sells more, it will
make a profit and if it sells FC/ (P-VC) units, it will make no profit and no loss.

2. Contribution Margin:

Contribution margin is the revenue minus all costs that vary with respect to an output-related cost
driver. This method uses the fact that:

P*N – VC*N-FC = operating income (OI)

N (P-VC) = OI+FC

Unit contribution margin * N = FC + OI

Since at the break-even point, operating income is by definition zero, we obtain;

Unit contribution margin * Break even No. of units = FC

Therefore, Break even no. of units= FC/ Unit contribution margin

A contribution income statement groups individual line items to highlight the contribution margin,
which is the difference between revenues and all costs that may vary with respect to an output-related
driver.

3. Graphical calculation:

A break-even chart is one in which sales revenue, variable costs, and fixed costs are plotted on the
vertical axis while volume is plotted on the horizontal axis. The Break-Even Point is the point at which
the total sales revenue line intersects the total cost line. The chart below shows the calculation of break-
even point graphically:

Here, the firm is at break-even at the point of intersection of the total revenue curve and the total cost
curve. The break-even point occurs when 1000 units of the commodity are produced. The important
concepts to be understood in this method are Variable costs, fixed costs and total revenue. These
concepts have already been explained in the previous sections.

The main advantages of break-even analysis are that it explains the relationship between costs,
production volume and returns. It can be extended to show how changes in fixed costs variable costs
relationship will affect the profit levels of a company and the breakeven points. Break even analysis is
most useful when used with partial budgeting or capital budgeting. Major benefit to using break even
analysis is that it indicates the lowest output to prevent a loss.

Limitations of break-even analysis include:

 It is best suited to the analysis of one product at a time

 May be difficult to classify a cost as all variable or all fixed cost
 It may be a tendency to continue to use a break-even analysis after the cost and income
function have changed.
INCREMENTAL ANALYSIS

Incremental analysis is a technique used to assist decision making by assessing the impact of small or
marginal changes. Its origins are linked to the principles of marginal analysis.

The most important principle of incremental analysis is that the only items relevant to a decision are
those that will be different as a result of the decision. A second and related tenet is that if a past cost or
negative is not recoverable or removable, it is irrelevant to a future decision. Those two principles have
universal application. Incremental analysis guides many decisions in nearly every discipline including
engineering, architecture, management, medicine, demography, sociology, consumer behavior and
investment management.

Incremental analysis is applicable to both short- and long-run issues, but is particularly suited to short
run decisions. In the short run, production capacity remains unchanged so, by definition, fixed costs do
not vary due to capacity shifts. In the long run, production capacity is changeable; more elements will
thus generally be required to be incorporated into an incremental analysis.

A simple situation in everyday life provides an example of incremental analysis. Consider a worker
leaving work to travel home. Groceries are required and can be purchased at slightly higher prices at a
store on the way from the work place to the home, or at lower prices by driving to a store 3 miles (4.82
km) from home. The worker decides to purchase the groceries on the way home since no incremental
travel costs are involved, and the incremental difference in grocery prices will be less than the value the
worker places on the time and other costs required to drive to the more distant store. In business, firms
routinely use incremental analysis to assist a large range of decisions, including leasing versus
purchasing of new assets, acquisitions and divestments, capacity expansions and additional raw material
processing decisions. A key issue usually is determining the incremental impact on capital outlays, costs,
and revenues. This is not always clear cut before the event and judgments are often required.
Margin of Safety (MOS)

Every enterprise tries to know how much above they are from the breakeven point. This is technically
called margin of safety. It is calculated as the difference between sales or production units at the
selected activity and the breakeven sales or production.

Margin of safety is the difference between the total sales (actual or projected) and the breakeven sales.
It may be expressed in monetary terms (value) or as a number of units (volume). It can be expressed as
profit / P/V ratio. A large margin of safety indicates the soundness and financial strength of business.

Margin of safety can be improved by lowering fixed and variable costs, increasing volume of sales or
selling price and changing product mix, so as to improve contribution and overall P/V ratio.

Profit at selected activity

Margin of safety = Sales at selected activity – Sales at BEP =
PV Ratio
The size of margin of safety is an extremely valuable guide to the strength of a business. If it is large,
there can be substantial falling of sales and yet a profit can be made. On the other hand, if margin is
small, any loss of sales may be a serious matter. If margin of safety is unsatisfactory, possible steps to
rectify the causes of mismanagement of commercial activities as listed below can be undertaken.

 Increasing the selling price-- It may be possible for a company to have higher margin of safety in
order to strengthen the financial health of the business. It should be able to influence price,
provided the demand is elastic. Otherwise, the same quantity will not be sold.
 Reducing fixed costs
 Reducing variable costs
 Substitution of existing product(s) by more profitable lines e. Increase in the volume of output
 Modernization of production facilities and the introduction of the most cost effective technology
APPLICATION

Application to investing

Using margin of safety, one should buy a stock when it is worth more than its price on the market. This is
the central thesis of value investing philosophy which espouses preservation of capital as its first rule of
investing. One should also analyze financial statements and footnotes to understand whether
companies have hidden assets (e.g., investments in other companies) that are potentially unnoticed by
the market.

The margin of safety protects the investor from both poor decisions and downturns in the market.
Because fair value is difficult to accurately compute, the margin of safety gives the investor room for
error.

A common interpretation of margin of safety is how far below intrinsic value one is paying for a stock.
For high quality issues, value investors typically want to pay 90 cents for a dollar (90% of intrinsic value)
while more speculative stocks should be purchased for up to a 50 percent discount to intrinsic value
(pay 50 cents for a dollar).

Application to accounting

In investing parlance, margin of safety is the difference between the expected (or actual) sales level and
the break-even sales level. It can be expressed in the equation form as follows:

Margin of Safety = Expected (or) Actual Sales Level (quantity or dollar amount) – Breakeven sales Level
(quantity or dollar amount).
Limitations

 For an organization of a reasonably large size, it is not possible to take a look at total costs and
split them into their fixed and variable elements. Not only might there be several hundred costs
comprising total cost but also there are many forces acting on those costs.
 It ignores the importance of the relevant range in fixed costs.
 Variable costs do not always vary directly with activity.
 Selling prices per unit are not always constant.
 It doesn’t consider the effect of labor efficiency on costs and revenues.
 It is difficult to apply this analysis to multi product businesses because simply by analysing the
total sales curve, and ignoring its constituent parts, is likely to lead to serious errors of
judgement or decision making

Effect of cost, production volume and sales on profit

The CVP-model is a mathematical model that allows a business to conduct a thorough cost-volume-
profit analysis. Regarding costs, the CVP model helps the business to evaluate the effects of cost on
changes in volume. The purpose of this type of analysis is to evaluate the profits earned and the costs
incurred. For example, if a business wants to buy new equipment to increase production levels, the new
machine may increase the fixed costs. A business can use CVP analysis to calculate the reduction in
variable costs necessary to maintain the same overall cost for a product.