CVP ANALYSIS AND LIMITING FACTOR ANALYSIS

Chapter 3

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Contents

1. Breakeven analysis and contribution

2. CVP analysis and target profit

3. Limiting factor analysis

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 Breakeven analysis and contribution

• Breakeven analysis or cost-volume-profit (CVP) analysis

is the study of the interrelationships between costs,
volume and profit at various levels of activity.
• The total contribution from the sales volume for a period
can be compared with the fixed costs for the period. Any
excess of contribution is profit, any deficit of contribution
is a loss.

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 Break-even analysis

Breakeven point:
The point where total
costs = total sales
revenue
&
Where there is neither a
profit or loss

Fixed costs
B/E Point (units) =
Contribution per unit

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 Break-even analysis
CVP Analysis
• Profit = (Contribution per unit x units) – Fixed costs
• Contribution = Sales value – all variable costs
A product has a sales price of £20 and a variable cost of £10
per unit
Units 0 100 500 1,000 1,500
Contribution (£) 0 1,000 5,000 10,000 15,000
Fixed costs (£) (10,000) (10,000) (10,000) (10,000) (10,000)
Profit (£) (10,000) (9,000) (5,000) 0 5,000

Contribution per unit 10 10 10 10

Profit per unit (90) (10) 0 33.33

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 Break-even analysis

Contribution to Sales ratio

Contribution to Sales Ratio (C/S ratio)

=
(Contribution per unit) / Unit Sales Price
=
Profit / Volume (P/V Ratio)

Breakeven Point in Sales Value

=
Fixed Costs / C/S ratio

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 Break-even analysis
The Margin of Safety
The Margin of Safety represents the level by which output can fall before
the organisation makes a loss

Budgeted output − Breakeven output

Margin of safety = x 100%
Budgeted output
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 Break-even analysis

The Margin of Safety

Example:
Mal de Mer Co makes and sells a product which has a
variable cost of £30 and which sells for £40. Budgeted fixed
costs are £70,000 and budgeted sales are 8,000 units.
Requirement
Calculate the breakeven point and the margin of safety.

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 Break-even analysis

The Margin of Safety

Solution
Total fixed costs £70,000
(a) Breakeven point = =
Contribution per unit £(40 −30)
= 7,000 units
(b) Margin of safety = 8,000 - 7,000 units = 1,000 units
which may be expressed as (1,000 units/8,000 units) x
100% = 12½% of budget
(c) The margin of safety indicates to management that actual
sales can fall short of budget by 1,000 units or 12½%
before the breakeven point is reached and no profit is
made.

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 Break-even analysis

CVP analysis and profit target

• Once the selling price and cost structure have been
established for a product or service, it is possible to
manipulate the data to provide a variety of information for
management decision
– Breakeven with required profit
Fixed costs + required profit
Sales for a certain level of profit =
Contribution per unit
– Breakeven with change in selling price to maintain current
profit
– Breakeven with change in production cost to maintain
current profit

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 Break-even analysis
Variations on breakeven and profit target calculations
You may come across variations on breakeven and profit target
calculations in which you will be expected to consider the effect of
altering the selling price, variable cost per unit or fixed cost.
Worked example:
Stomer Cakes Ltd bake and sell a single type of cake. The variable
cost of production is £0.15 per cake and the current sales price is
£0.25 per cake. Fixed costs are £2,600 per month, and the annual
profit for the company at the current sales volume is £36,000. The
volume of sales demand is constant throughout the year.
The sales manager wishes to raise the sales price to £0.29 per
cake, but considers that a price rise will result in some loss of sales.
Requirement: Ascertain the volume of sales required each month
to maintain current profitability, if the selling price is raised to £0.29.

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 Break-even analysis
Worked example: Change in production costs
Close Brickett Ltd makes a product which has a variable
production cost of £8 and a variable selling cost of £2 per unit.
Fixed costs are £40,000 per annum, the sales price per unit is
£18, and the current volume of output and sales is 6,000 units.
The company is considering whether to hire an improved
machine for production. Annual hire costs would be £10,000 and
it is expected that the variable cost of production would fall to £6
per unit.
Requirements
(a) Determine the number of units that must be produced and
sold to achieve the same profit as is currently earned, if the
machine is hired.
(b) Calculate the annual profit with the machine if output and
sales remain at 6,000 units per annum.

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 Break-even analysis
Limitations/Assumptions of CVP
• Can only apply to a single product or constant mix of a
group of products
• Time consuming to prepare breakeven chart
• Costs behaviour is assumed to be linear
• Revenue is assumed to be linear
• Volume Produced = Volume Sold
• Ignores inflation and uncertainty in the estimates of
sales prices, fixed costs and variable cost per unit

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 Limiting Factors Analysis

• A limiting factor (or key factor) is any factor that is in

scarce supply and that stops the organization from
expanding its activities further, that is, it limits the
organization’s activtities
– Labour
– Materials
– Manufacturing capacity
• In limiting factor analysis, management wishes to
maximize profit and that since there is no change in the
fixed cost incurred, profit will be maximized when
contribution is maximized.

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 Limiting factors analysis

• Contribution will be maximized by earning the biggest

possible contribution per unit of limiting factor.
• Where there is just one limiting factor, the technique for
establishing the contribution maximizing product or service
mix is to rank the products or services in order of
contribution-earning ability per unit of limiting factor.

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 Limiting factors

Solution
1. Calculate contribution per unit.
2. Calculate contribution per unit of the limiting factor.
3. Rank in order.
4. Allocate resources - make first up to max demand, then
second,...

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