LECTURE 7 COST-VOLUME-PROFIT ANALYSIS (BREAK-EVEN ANALYSIS)

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LEARNING OBJECTIVES

At the end of the lesson students should be able to: Explain the objective of CVP analysis Explain the concept of break-even Calculate and explain the break-even point and revenue, target profit, profit/volume ratio and margin of safety Construct break-even, contribution, and profit/volume charts from given data.

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Cost-Volume-Profit Analysis

The concept of c-v-p analysis examines the inherent relationship that exists among selling price, cost structure, volume and profits. It involves considering the combined effect on both cost and revenue functions of changes in the level of output by examining the interrelation of cost, volume and profits. It seeks to answer such questions as: 1. Given existing prices and cost structure what volume of operation is needed to earn a certain level of profit.
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Cost-Volume-Profit Analysis
2. If prices are cut by a certain percentage how much of an increase in volume is needed to maintain the previous level of profits; 3. If variable costs are to be cut by the acquisition of some automation machine (hence an increase in fixed cost), how large a cut is required to provide a certain level of profit assuming the existing level of operation continues in the future. 4. If variable costs increase by a certain percentage what happens to profit assuming that volume will increase by a certain percentage

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Cost-Volume-Profit Analysis
An understanding of cost behaviour and costvolume-profit relationship can help to answer these questions as well as long-term questions such as the additional sales required to justify an increase in profit.
The cost-volume-profit analysis is based on a model of Income Statement using the Marginal

Costing approach where Total Cost is divided into Fixed and Variable components.
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Cost-Volume-Profit Analysis
Under Marginal Costing, Contribution Margin is the

difference between product revenue and variable cost. (C = TR VC). It represents the amount available first for meeting fixed cost and then for contributing towards profit expectation. (C = FC + P)

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Cost-Volume-Profit Analysis
Illustration Asempa Ltd. manufactures a product which is sold for GH20.00 per unit and has variable costs of GH14.00 per unit. Fixed cost per annum is estimated at GH24,000. Required: Prepare summary statements showing the total profit/(loss) and profit/(loss) per unit where sales quantity may be 3,000, 4,000 and 5,000units.

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Cost-Volume-Profit Analysis
Solution: ASEMPA LTD. INCOME STATEMNTS Sales Units

3,000 4,000 5,000 T U T U T Sales Rev. 60,000 20 80,000 20 100,000 Variable Cost 42,000 14 56,000 14 70,000 Contribution 18,000 6 24,000 6 30,000 Fixed Cost 24,000 8 24,000 6 24,000 Profit/(Loss) (6,000) (2) 0 0 6,000
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U 20 14 6 4.80 1.20
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Cost-Volume-Profit Analysis
Solution may be analysed as follows: Fixed Cost remains constant at GH24,000

irrespective of the sales volume. Fixed cost per unit is an arbitrary measure which is obtained by dividing total cost by the number of units of sale. Fixed cost per unit falls as sales volume increases. Contribution is the difference between sales revenue and variable cost.

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Cost-Volume-Profit Analysis
Contribution per unit is a constant figure of GH6.00 per unit (20 - 14) at all sales levels. Total contribution increases as sales volume increases. The point at which profit is zero is the break-even point. At this point total contribution equals fixed cost. Below 4,000 units of sales, fixed costs are greater than total contribution and a loss results.

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Cost-Volume-Profit Analysis
Above 4,000 units of sale, total contribution is greater than fixed costs and a profit results.
Note that contribution increases by GH6,000 (from 24,000 to 30,000) when sales volume increases from 4,000 to 5,000 units. Profit also increases by GH6,000 for the same sales volume range (0 to 6,000), whereas fixed costs remain unchanged at GH24,000.

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Cost-Volume-Profit Analysis
This indicates that the additional contribution earned per unit is also the extra profit earned per unit. This is a useful tool in profit planning. For example, the increase in profit where sales rise from 5,000 to 5,400 units can be measured as (400 units x 6.00 = 2,400). This increases the total profit to GH8,400. (6,000 + 2,400).

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Cost-Volume-Profit Analysis
Check: Sales Units Sales Revenue Variable Cost Contribution Fixed Cost Profit
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5,400 T

108,000 75,600 32,400 24,000 8,400

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Contribution/Sales Ratio (c/s)

This ratio is an alternative to the contribution per unit as a measure of the rate at which contribution is being earned.
Using the figures in the earlier example, it may be calculated as: contribution per unit / selling price (c/s) (6/20 = 0.30 or 30%).
This ratio applies at any activity level as long as the basic

assumptions of the model remain unchanged. (i.e. constant selling price and variable cost per unit.)
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Contribution/Sales Ratio (c/s)

Where business activity is expanding, the higher the

c/s ratio, the greater the rate at which additional profits will be earned. Where business activity is declining, however, a higher c/s ratio means that profits will fall at a greater rate per unit of lost sales.

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Break-even Analysis
Basic Assumptions: Cost can be segregated into two components:

fixed and variable cost elements. Cost and Revenue behaviour is a linear relationship over the relevant range of output levels. This implies that:
Variable cost varies with the level of output. Increases in

output have identical effect on cost as on size per unit. The cost identified as fixed is constant within the range of output levels considered. The selling price of the product remains unchanged regardless of the level of sales.

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Break-even Analysis
Efficiency in productivity remains unchanged. The analysis of break-even relates to one product only or where multi-products are produced, it relates to a constant mix of products. Sales and production units are equal implying that stock level is zero. Volume is the only factor which affects cost The prices paid for the resources used by enterprise will not change over the period.

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Break-even Analysis
Illustration of Break-even charts.
Traditional Break-even Charts Modified Break-even Chart Contribution/Volume Chart Profit/Volume Chart

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Traditional Break-even Chart

Example
C O S T / R E V S

FC

OUTPUT

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Modified Break-even Chart

Example
C O S T / R E V 0 S

FC

OUTPUT

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Profit/Volume Chart
Example.
P R O F I T

B/E
OUTPUT

0
L O S S

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Contribution/Volume Chart
Example
C O N T R I B U T I O N

C
B/E FC

OUTPUT

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Break-even Analysis
Calculating Sales units or value at Break-even and at

specific profit. Two methods can be used: Preparing Break-even chart and reading the required value from it. Use a formula derived from the revenue function: (Sales Revenue (S) = Variable cost (V) + Fixed cost (F) + Profit (P).

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Break-even Analysis
1. 2.

3.
4. 5.

Steps in the preparation of Break-even chart: Choose suitable scales for the horizontal axis (activity units axis) and the vertical axis (sales value and cost). Plot the point for the maximum sales revenue. Join this point to the origin (when no units are sold sales revenue is zero). The resulting line is the Sales curve. Plot the point for fixed cost on the vertical axis. When sales units are zero there is no variable cost. Plot the total cost point at the maximum units. This is variable cost plus fixed cost. Join the points from 3 and 4 to give the straight line which is the total cost curve. The required information can then be read.

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Break-even Analysis
Deriving formulae from the sales function: S=V+F+P Hence S V = F + P But S V = C So C = F + P By dividing both sides of the equation by Sales Revenue (S) gives: C/S = (F + P) / S Re-arranging to make S the subject: S = (F + P) / C/S.
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Break-even Analysis
From the equation, Sales revenue (S) for any desired level

of profit (P) can be calculated when fixed cost and c/s ratio are known. For sales revenue at Break-even point, P = 0, hence, S = F / c/s. C = F + P; but C = Q * c (Total Contribution is equal to Quantity multiplied by contribution per unit.) To make Q the subject of the equation, C /c = Q; therefore F + P/c = Q (i e. The Quantity at desired profit) S units = F / c per unit for Break-even quantity.

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Example
A company has a budget summary as follows: Fixed cost is GH50,000

Variable cost per unit is GH20 Selling price per unit is GH30 Sales will be in the range up to 8,000 units. Required: Calculate the sales revenue and sales units at which the companys budget will show: (a) a break-even position, (b) a profit of GH20,000 and (c) a loss of GH10,000, using: (i) Break-even chart and (ii) the formula.
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Solution
(ii) Using formula: or S at B/E = FC / C/S ratio or FC divided by CS ratio Cont=sales-vc = 30-20=10 FC= 50,000, CS ratio= 10/30 x 100 =33.3% BE = 50,000/33.3%= 150,000 or 50,000 x 30 = 150,000 10 S units at B/E = F / c per unit Q = 50,000 = 5,000 units 10 S at Profit of 20,000: S = F + P / c/s ratio S = (50,000 + 20,000) x 3 = 210,000 1 GIMPA BUSINESS SCHOOL MBA 14/06/2013

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Solution
S units at 20,000 Profit Q = (F + P)/c per unit Q = (50,000 + 20,000) = 7,000 units

10 S at 10,000 Loss S = (F + P)/c/s ratio S = (50,000 10,000) x 3 = 20,000 1 S units at 10,000 Loss Q = (F + P)/c per unit Q = (50,000 10,000) / 10 = 4,000 units
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Margin of Safety
Is the extent to which sales may fall below their existing level before break-even point is reached. It may be expressed in units, monetary value or as a percentage of the existing level. The Margin of Safety is an additional useful statistic available as part of c-v-p analysis. It will help management to evaluate alternative proposed strategies.

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Margin of Safety
Example:
KK Ltd. has planned sales of GH600,000 (40,000 @

15 per unit). The variable cost per unit is 10 and the fixed costs total 150,000.
Required: Calculate the margin of safety expressed in

terms of sales units, sales value and as a percentage of current sales.

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Margin of Safety
Solution: Contribution per unit: 15 - 10 = 5

S = F / c per unit S units = 150,000 / 5 = 30,000 units

Break-even Sales = 30,000 x 15 = 450,000.

The Margin of Safety may be valued as:
40,000 units 30,000 units = 10,000units 600,000 - 450,000 = 150,000. As percentage: 150,000/600,000 x 100 = 25%.

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Exercise
The summary Income Statements of two companies as at 31 December 2009 were:
Sales Revenue Variable Cost Contribution

Fixed Cost
Profit
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A Co . Ltd. GH 100,000 40,000 60,000 45,000 15,000

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B Co. Ltd. GH 100,000 50,000 50,000 35,000 15,000

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Exercise

Required: Calculate the Break-even Sales for each company. Calculate the Margin of Safety and Contribution/Sales Ratio for each company. In which of the two companies should one invest during times of (i) high demand (ii) low demand The two companies operate in the same market and produce the same product.

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