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Cost-Volume-Profit Analysis
Cost-volume profit (CVP) analysis examines the behavior of total revenues, total cost and
operating income as changes occur in the output level, selling price, variable costs per unit or
fixed costs.
Managers often classify costs as fixed or variable when making decisions that affect the volume
of output. The managers want to know how such decision will affect costs and revenues. They
realize that many factors in addition to the volume of output will affect cost. Yet, a useful
starting point in their decision process is to specify the relationship between the volume of out
puts and costs and revenues.
The mangers of profit-seeking organizations usually study the effects of output volume on
revenue (sales), expenses (costs) and net income (net profit). This study is commonly called cost-
volume-profit (CVP) analysis. The mangers of nonprofit organizations also benefit from the
study of CVP relationships. Why? No organization has unlimited resources, and knowledge of
how cost fluctuate as volume changes helps managers to understand how to control costs. For
example, administrators of nonprofit hospitals are constantly concerned about the behavior of
costs as the volume of patients fluctuates.
To apply CVP analysis, mangers usually resort to some simplifying assumptions. The major
simplification is to classify costs as either variable or fixed with respect to a measure of the
volume of output activity. That is, all costs must be classified as either fixed or variable with
respect to production or sales volume before CVP analysis can be used.
CVP analysis can be used to develop predictions of what can happen under alternative strategies
concerning sales volume, selling price, variable costs or fixed costs. Applications include “what
if” analysis. For example, how will revenues and cost be affected if we sell 1,000 more units? If
we raise or lower our selling prices?, If we expand business in to overseas markets? By
examining various possibilities and alternatives, CVP analysis illustrates various decision
outcomes and thus serves as an invaluable aid in the planning process.
THE OBJECTIVE OF CVP ANALYSIS
CVP analysis looks primarily at the effects of differing levels of activity on the financial results
of a business. The reason for the particular focus on sales volume is because, in the short-run,
sales price, and the cost of materials and labor, are usually known with a degree of accuracy.
Sales volume, however, is not usually so predictable and therefore, in the short-run, profitability
often hinges upon it. For example, Company A may know that the sales price for product x in a
particular year is going to be in the region of $50 and its variable costs are approximately $30.
It can, therefore, say with some degree of certainty that the contribution per unit (sales price less
variable costs) is $20. Company A may also have fixed costs of $200,000 per annum, which
again, are fairly easy to predict. However, when we ask the question: ‘Will the company make a
profit in that year?’, the answer is ‘We don’t know’. We don’t know because we don’t know the
Profit
Total revenue line
3000, 000
Total cost line
2,000,000
1,000,000 Breakeven point = 4,500,000
900,000
Eg. Company A wants to achieve a target profit of $300,000. The sales volume necessary in
order to achieve this profit can be ascertained using any of the three methods outlined above. If
the equation method is used, the profit of $300,000 is put into the equation rather than the profit
of $0:
Finally, the answer can be read from the graph, although this method becomes clumsier than the
previous two. The profit will be $300,000 where the gap between the total revenue and total cost
line is $300,000, since the gap represents profit (after the break-even point) or loss (before the
break-even point.)
Target net income = (Target operating income) – (Target operating X tax rate
Income
TNI
FC+
1−TR
Q=
UCM
TNI
FC+
1−TR
CM %
Target revenue=
Unlike in the single product (or service) situation, there is no unique breakeven number of units
for a multiple- product situation. The breakeven quantity depends on the sales mix. One possible
assumption is that the budgeted sales mix will change at different levels of total unit sales.
Breakeven point (in units) for multiproduct companies is computed using the following formula:
FC
QBEP =
WACM
Illustration on computation of BEP for multiple product company (sales mix and breakeven point)
Given the following data work out the requirements
Given
Name of company:- SS company
Number of types of products: - Two
Types of products: - LL CD and VV CD
Additional information: - sales in the current month;
LL CD VV CD Total
Item Amount Percent Amount Percent Amount Percent
Sales Br.20000 100% Br.80000 100% Br100000 100%
Less var. cost Br.15000 75% Br.40000 50% Br.55000 55%
CM Br.5000 25% Br.40000 50% Br.45000 45%
Fixed Expenses Br.27000
Solution
Overall BEP=Fixed cost/overall CM-ratio=Br. 27,000/0.45=Br. 60,000 and at this BEP, sales of
LL CD and VV CD should be Br. 12,000 and Br.48,000 respectively.
Example 2
Suppose Ramos Company has two products, wallets (W) and Belt (B). The income budget is as
follows:
Wallets (W) Belt ( B) Total
Sales in units 300,000 75,000 375,000
Sales @ $ 8, and $ 5 2,400,000 375,000 2,775,000
Variable expenses @ $ 7 and $ 3 2,100,000 225,000 2,325,000
Contribution margin @ $ 1 and $ 2 300,000 150,000 450,000
Fixed costs 180,000
Net income $270,000
Required: Calculate the breakeven point. Assume that there is no change in sales mix and ignore
income taxes.
Since the sales mix will not be changed there is a constant mix of 4 units of W, for every
unit of B i.e. 300,000: 75,000 or 4: 1 or 80%: 20%. Therefore W= 4B.
Solution
Method 1 = [(8W – 7W) + (5B – 3B)] – 180,000 = 0
= (32B – 28B) + (5B – 3B) - 180,000 = 0
B = 30,000 units
W = 4B = 4 (30,000 units) = 120,000 units
Method 2 = we have to calculate the weighted-average contribution margin per unit for the two
products together at the sales mix.
WACM per unit = Wallets (W) CM per unit X Q of W sold + Belt (B) CM per unit X Q of B
sold
Number of Q of W sold + number Q of B sold
= $1 per unit X 300,000 units + $2 per unit X 75,000 units = $1.2 per unit
300,000 + 75,000
We have then BEP = FC
CM per unit
= $180,000 = 150,000 units
We can also calculate the breakeven point revenues for the multiproduct situation using the
WACM percentage.
WACM% = Total contribution margin =450,000 =0.1621621621621622
=16.21621621621622%
Total revenues 2,775,000
Total revenues to require at BEP = FC = $180,000 = 1,110,000
WACM% 0.1621621621621622
The total revenues of $2,775,000 are in the ratio of 2,400,000:375,000 or 86.5%: 13.5%.
Hence the breakeven revenues of $1,110,000 should be split in the same ratio, 86.5%:13.5%.
Managers usually want to maximize the sales of all their products. Faced with limited resource
and time, however, executive prefer to generate the most profitable sales mix achievable.
Profitability of a given product helps guide executive who must decide to emphasize or de-
emphasize particular products. For example given limited production facilities or limited time of
sales personnel, should we emphasize wallets or ray cases? These decisions may be affected by
other factors beyond the contribution margin per unit of product.
In general, other things being equal, for any given total quantity of units sold, if the sales mix
shifts toward unit with higher contribution margins operating income will be higher.
CVP Analysis in service and non-profit organizations
CVP analysis can be applied in service and NFP organizations in measuring their output.
Examples of output measures in venous service and not profit industries follow:
1.8. Limitations of CVP Analysis - The CVP analysis is generally made under certain limitations
and with certain assumed conditions, some of which may not occur in practice. Following are the
main limitations and assumptions in the cost-volume-profit analysis:
1. It is assumed that the production facilities anticipated for the purpose of cost-volume-profit
analysis do not undergo any change. Such analysis gives misleading results if expansion or reduction
of capacity takes place.
2. In case where a variety of products with varying margins of profit are manufactured, it is difficult
to forecast with reasonable accuracy the volume of sales mix which would optimize the profit.
3. The analysis will be correct only if input price and selling price remain fairly constant which in
reality is difficult to find. Thus, if a cost reduction program is undertaken or selling price is changed,
the relationship between cost and profit will not be accurately depicted.
4. In cost-volume-profit analysis, it is assumed that variable costs are perfectly and completely
variable at all levels of activity and fixed cost remains constant throughout the range of volume being
considered. However, such situations may not arise in practical situations.
5. It is assumed that the changes in opening and closing inventories are not significant, though
sometimes they may be significant.
6. Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore, closing
stock carried over to the next financial year does not contain any component of fixed cost. Inventory
should be valued at full cost in reality.