Chapter 16

Volume-Cost-Profit
Analysis
VOLUME-COST-PROFIT
ANALYSIS

BREAK-EVEN ANALYSIS
Volume-Cost-Profit Analysis

The cost-volume-profit (CVP) analysis is a tool to show the

relationship between various ingredients of profit
planning, namely, unit sales price (SP), unit
variable cost (VC), fixed costs (FC), sales
volume, and sales-mix (in the case of
multi-product firms).

The crucial step in this analysis is the determination of

break-even point (BEP), which is defined as the sales
level at which the total revenues equal total costs.
It is the level at which losses cease and beyond
which profit starts.
 Break-Even Point

BEP can be determined by the following

two methods
(1) Algebraic Methods (2) Graphic Presentation
a) Contribution margin a) Break-even chart
approach
b) Equation technique b) Volume-profit graph
 1(a) Contribution Margin
Approach
Contribution margin is the excess of unit sale price over unit variable cost

Example 1: “How many ice-creams, having a unit cost of Rs 20 and a

selling price of Rs 30, must a vendor sell in a fair to recover the Rs 8,000
fees paid by him for getting a selling stall and additional cost of Rs 4,000
to install the stall?” The answer can be determined by dividing the fixed
cost by the difference between the selling price (Rs 30) and cost price (Rs
20). Thus
Fixed cost (Entry fees + Stall expenses)
BEP (units) =
(Sales price – Unit variable cost)
(Rs 8,000 + Rs 4,000)/(Rs 30 – Rs 20) = 1,200 units
Fixed costs
BEP (units) =
Contribution margin (CM) per unit
BEP (amount)/BEP (Sales revenue)/BESR = BEP (units) × Selling price (SP)
per unit = 1,200 × Rs 30 = Rs 36,000
 Fixed costs
BEP (amount) =
Profit volume ratio (P/V ratio)
Contribution margin per unit
P/V ratio =
Selling price per unit
BEP (amount) = 1/3 = 33.33%
= Rs 12,000 ÷ 0.3333 = Rs 36,000
From the P/V ratio, the variable cost to volume ratio (V/V ratio) can be easily
derived:
V/V ratio = 1 – P/V ratio
In the vendor’s case, it is = 1–1/3 = 2/3 = 66.67 per cent
The V/V ratio, as the name suggests, establishes the relationship between
variable costs (VC) and sales volume in amount. The direct method of its
computation is:
Variable cost
= Rs 20 ÷ Rs 30 = 66.67 per cent
Sales revenue
Thus, P/V ratio + V/V ratio = 1 or 100 per cent
(1/3 + 2/3) = 1 (33.33 per cent + 66.67 per cent) = 100 per cent
 Margin of Safety
Margin of safety is the excess of actual sales revenue over the break-even
sales revenue.
The excess of the actual sales revenue (ASR) over the break-even sales revenue
(BESR) is known as the margin of safety. Symbolically, margin of safety = (ASR
– BESR)
When the margin of safety (amount) is divided by the actual sales (amount), the
margin of safety ratio (M/S ratio) is obtained. Symbolically,
M/S ratio = (ASR – BESR)/ASR
Assume in the vendor’s case that sales is 2,000 units (Rs 60,000); margin of
safety (Rs 60,000 – Rs 36,000) = Rs 24,000; and the M/S ratio is Rs 24,000 ÷ Rs
60,000 = 40 per cent.
The amount of profit can be directly determined with reference to the margin of
safety and P/V ratio. Symbolically,
Profit = [Margin of safety (amount)] × P/V ratio
Or Profit = [Margin of safety (units) × CM per unit]
In the vendor’s case, profit = Rs 24,000 × 0.3333 (33.33 per cent) = Rs 8,000 or
800 × Re 10 = Rs 8,000.
The reason is that once the total amount of fixed costs has been recovered,
profits will increase by the difference of sales revenue and variable costs.
 1( b) Equation technique

The equation technique is particularly useful in

situations where unit price and unit variable costs are
not clearly defined. The excess of actual sales over the
BE sales is the margin of safety. When margin of safety
is divided by the actual sales, we get margin of safety
ratio which indicates the percentage by which actual
sales may decline without causing any loss to the firm
Sales revenue-Total costs = Net profit
Breaking up total costs into fixed and variable, Sales revenue – Fixed
costs – Variable costs= Net profit. Or Sales revenue = Fixed costs +
Variable costs + Net profit.
If S be the number of units required for break-even and sales revenue
(SP) and variable costs (VC) are on per unit basis, the above equation
can be written as follows:
SP (S) = FC + VC (S) + NI
Where SP = Selling price per unit
S= Number of units required to be sold to break-even
FC= Total fixed costs
VC= Variable costs per unit
NI= Net income (zero)
SP (S)= FC + VC (S) + zero
SP (S) – VC (S)= FC
Example 2
SV Ltd, a multi-product company, furnishes you the following data
relating to the current year:
Particulars First half of the year Second half of the year
Sales Rs 45,000 Rs 50,000
Total costs 40,000 43,000
Assuming that there is no change in prices and variable costs and
that the fixed expenses are incurred equally in the two half-year
periods, calculate for the year:
(i)The profit-volume ratio, (ii) Fixed expenses, (iii) Break-even sales,
and (iv) Percentage margin of safety.
Solution
Sales revenue – Total costs = Net profit
Rs 45,000 – Rs 40,000 = Rs 5,000 (first half)
Rs 50,000 – Rs 43,000 = Rs 7,000 (second half)
On a differential basis: ∆ Sales revenue, Rs 5,000 – ∆ Total costs, Rs
3,000 = ∆ Total profit, Rs 2,000.
We know that only VC changes with a change in sales volume and, hence,
change in total costs are equivalent to VC (Rs 3,000). Accordingly, the
additional sales of Rs 5,000 has earned a contribution margin of Rs 2,000 [Rs
5,000 (S) – Rs 3,000 (VC)].
P/V ratio = Rs 2,000 ÷ Rs 5,000 = 40 per cent.
V/V ratio = 100 per cent – 40 per cent = 60 per cent.
Accordingly, 60 per cent of the total costs are made up of variable costs and
the balance represents the total fixed costs (FC).
Sales revenue = Fixed costs + Variable costs + Net profit
Rs 95,000 = FC + 0.60 × (Rs 95,000) + Rs 12,000
Rs 95,000 = FC + Rs 57,000 + Rs 12,000
Rs 95,000 – Rs 69,000 = FC or Rs 26,000 = FC
BEP (amount) = Rs 26,000 ÷ 0.40 = Rs 65,000
Verification
  Particulars Amount  Per cent
Break-even sales Rs 65,000 100
Variable costs 39,000 60
Contribution 26,000 40
Fixed costs 26,000 40
Net income Nil Nil

(Rs 95,000 – Rs 65,000)

M/S ratio = = 31.58%
Rs 95,000
 Break-Even Application
Sales Volume Required to Produce Desired Operating Profit  
(Fixed expenses + Desired operating profit) ÷ P/V ratio
In Example 2, if the desired operating profit of SV Ltd is Rs 13,000,
required sales volume = (Rs 26,000 + Rs 13,000)/0.35 = Rs 1,15,000
Operating Profit at a Given Level of Sales Volume  
[Actual Sales Revenue (ASR) – Break-even Sales Revenue (BESR)]
× P/V ratio
Effect on Operating Profit of a Given Increase in Sales Volume
[Budgeted Sales Revenue (BSR) – BESR] × P/V ratio
Suppose that SV Ltd forecasts 10 per cent increase in sales next
year, the projected profit will be: (Rs 1,04,500 – Rs 65,000) × 0.35 =
Rs 13,825
Additional Sales Volume Required to Offset a Reduction
in Selling Price  
Suppose that SV Ltd reduces its selling price from Rs 10
a unit to Rs 9. The sales volume needed to offset
reduced selling price/maintain a present operating profit
of Rs 12,000 would be:
Desired profit (P) + Fixed expenses
= Rs (12,000 + Rs 26,000) ÷
(FC)
0.3333 = Rs 1,14,000
Revised P/V ratio (Rs 3/Rs 9)
The required sales volume of Rs 1,14,000 represents an
increase of about 20 per cent over the present level. The
management should explore new avenues of sales
potential to maintain the existing amount of profit
Effect of Changes in Fixed Costs  
A firm may be confronted with the situation of increasing fixed costs. An
increase in the total budgeted fixed costs of a firm may be necessitated
either by external factors, such as, an increase in property taxes, insurance
rates, factory rent, and so on, or by a managerial decision of an increase in
salaries of executives. More important than this in the latter category are
expansion of the present plant capacity so as to cope with additional
demand. The increase in the requirements of fixed costs would imply the
computation of the following:
(a) Relative break-even points.
(b) Required sales volume to earn the present profits.
(c) Required sales volume to earn the same rate of profit on the proposed
expansion programme as on the existing ones.
The effect of the increased FCs will be to raise the BEP of the firm. Assume
the management of SV Ltd decides a major expansion programme of its
existing production capacity. It is estimated that it will result in extra fixed
costs of Rs 8,000 on advertisement to boost sales volume and another Rs
16,000 on account of new plant facility.
(a) The relative BEPs will be:
Present facilities = Fixed costs ÷ P/V ratio = Rs 26,000/0.40 = Rs
65,000.
Proposed facilities = (Present FCs + Additional FCs) ÷ P/V ratio.
= (Rs 26,000 + Rs 24,000)/0.40 = Rs 125,000.
It may be noted that increase in FCs (from Rs 26,000 to Rs 50,000)
has caused disproportionate increase in the BEP (from Rs 65,000 to
Rs 1,25,000).
(b) The required sales volume to earn the present profit
[Present FCs + Additional FCs + Present profit (NI)] ÷ P/V ratio.
= [Rs 26,000 + Rs 24,000 + Rs 12,000] ÷ 0.40 = Rs 1,55,000.
(c) The required sales volume to earn the present rate of profit on
investment:
(Present FCs + Additional FCs + Present return on investment +
Return on new investment) P/V ratio.
Let us assume that the present investment is Rs 1,00,000 and the new
investment will involve an additional financial outlay of Rs 60,000. The
required sales volume will be (Rs 26,000 + Rs 24,000 + Rs 12,000+ Rs 7,200
(0.12 × Rs 60,000)/0.40 = Rs 1,73,000.
These computations may be reported in a summary form to the management
as follows (Table 1).
Table 1: Effect of Changes in Fixed Costs
Particulars Present Prospective Increase
facilities facilities
Fixed costs Rs 26,000 Rs 50,000 Rs 24,000
BEP sales volume 65,000 1,25,000 60,000
BEP sales volume (units) 6,500 12,500 6,000
Sales volume to earn existing 95,000 1,55,000 60,000
profit
Sales volume in units to earn 9,500 15,500 6,000
existing profit
Sales volume to earn existing ROI 95,000 1,73,000 78,000
Sales volume to earn existing ROI 9,500 17,300 7,800
(in units)
Effect of Changes in Variable Costs    
Assuming an increase of VC by Re 1 a unit for SV Ltd, the new contribution
margin will be: Rs 3 (Rs 10 – Rs 7) and the revised P/V ratio 0.30 that is, (Rs 3
÷ Rs 10).
Revised BEP = (Rs 26,000)/0.30 = Rs 86,667
Desired sales volume to earn existing profit = Rs 38,000/0.30 = Rs 1,26,667
Assuming that variable costs of SV Ltd decline by Re 1 per unit, revised BEP
= Rs 26,000/0.50 = Rs 52,000.
Desired sales volume to maintain existing profit = Rs 38,000/0.50 = Rs 76,000.

Effects of Multiple Changes 

So far we have assumed that a change takes place in one of the three
variable affecting profits—cost, price and sales volume. In cases where more
than one factor is affected, the BEP analysis can be applied as shown below:
Desired NI
FC + FC (new) +
1 – tax rate
[Contribution margin per unit (New SP – New VC) ÷ New selling price (New
SP)]
Assuming the following set of new Figures for SV Ltd:
 Particulars Existing data New data
Selling price per unit Rs 10 Rs 11
Fixed costs 26,000 40,000
Variable cost per unit 6 5.50
Contribution margin per unit 4 5.50
Desired net income after taxes (to maintain 12,000 25,000
the existing ROI)
Tax rate  35 per cent
Solution
Desired sales volume (on the basis of new data) [Rs 26,000 + Rs 14,000 +
(Rs 25,000÷0.65)] ÷ 0.50, that is (Rs 5.5 ÷ Rs 11) = (Rs 78,461.5) ÷ 0.50 = Rs
1,56,923
Desired sales volume on the basis of existing data = [Rs 26,000 + (Rs
12,000 ÷ 0.65)] ÷ 0.40 (Rs 4 ÷ Rs 10) = Rs 44,462 ÷ 0.40 = Rs 1,11,154.
Multi-product Firms (Sales-mix)
Example 3
The Garware Paints Ltd presents to you the following income statement in a
condensed form for the first quarter ending March 31:
Particulars Product Total
X Y Z
Sales Rs 1,00,000 Rs 60,000 Rs 40,000 Rs 2,00,000
Variable costs 80,000 42,000 24,000 1,46,000
Contribution 20,000 18,000 16,000 54,000
Fixed costs 27,000
Net income 27,000
P/V ratio 0.20 0.30 0.40 0.27
Break-even sales 1,00,000
Sales-mix (per cent) 0.50 0.30 0.20 100
If Rs 40,000 of the sales shown for Product X could be shifted equally to
products Y and Z, the profit and the BEP would change as shown in Table 2.
Table 2 Break-even Point
Particulars Product Total
X Y Z
Sales Rs 60,000 Rs 80,000 Rs 60,000 Rs 2,00,000
  Less: Variable costs 48,000 56,000 36,000 1,40,000
Contribution 12,000 24,000 24,000 60,000
  Less: Fixed costs 27,000
Net income 33,000
P/V ratio 0.20 0.30 0.40 0.30
BE sales 90,000
Sales-mix (per cent) 0.30 0.40 0.30 100
Example 3 shows that by increasing the mix of high P/V products (Y from 30
to 40 per cent, Z from 20 to 30 per cent) and decreasing the mix of a low P/V
product (X from 50 to 30 per cent), the company can increase its overall
profitability. In fact, it can further augment its total profits, if it can make,
and the market can absorb, more quantities of Y and Z, say Rs 1 lakh each
(Table 3).
Table 3
Particulars Product Total
Y Z
Sales Rs 1,00,000 Rs 1,00,000 Rs 2,00,000
  Less: Variable costs 70,000 60,000 1,30,000
Contribution 30,000 40,000 70,000
  Less: Fixed costs 27,000
Net income 43,000
P/V ratio 0.30 0.40 0.35
BE sales 77,143
Sales-mix (per cent) 0.50 0.50 100
From the above, it can be generalised that, other things being equal,
management should stress products with higher contribution margins. For
individual product line income statements, fixed costs should not be
allocated or apportioned.
 2(a) Break-Even Chart
The break-even chart is a graphic presentation of the relationship between
costs, profits, and sales. It shows not only the break-even sales but also
the estimated costs and profit at various levels of the sales revenue. It is,
therefore, also referred to as volume-cost-profit (VCP) graph/chart
Assumptions Regarding the VCP Graph are
1. Costs can be bifurcated into variable and fixed components.
2. Fixed costs will remain constant during the relevant volume range of
graph.
3. Variable cost per unit will remain constant during the relevant volume
range of graph.
4. Selling price per unit will remain constant irrespective of the quantity
sold within the relevant range of the graph.
5. In the case of multi-product companies, in addition to the above four
assumptions, it is assumed that the sales-mix remains constant.
6. Finally, production and sales volumes are equal.
Example 4
Selling price per unit Rs 10
Fixed costs 60,000
Variable costs per unit 5
Relevant range (units) : Lower limit 6,000
: Upper limit 20,000
Break-up of variable costs per unit:
Direct material Rs 2
Direct labour 1.50
Direct expenses 1
Selling expenses 0.50
Actual sales, 18,000 units (Rs 1,80,000)
Plant capacity, 20,000 units (Rs 2,00,000)
Tax rate, 50 per cent
Figure 1: Volume-Cost-Profit Graph (Traditional)
Figure 1 has been drawn by using a sales line and a total cost line (including both
fixed and variable costs). The steps involved in drawing the VCP graph are
enumerated as follows:
1. Select an appropriate scale for sales volume on the horizontal axis, say, 2,000 units
(Rs 20,000) per square, and plot the point for total sales revenues at relevant
volume: 6,000 units × Rs 10 = Rs 60,000. Draw the sales line from the origin to Rs
2,00,000 (the upper limit of the relevant range). Ensure that all the points, 0, Rs
60,000 and Rs 2,00,000 fall in the same line. This should be ensured for the total
cost line also.
2. Select an appropriate scale for costs and sales revenues on the vertical axis, say,
Rs 10,000 per square. Draw the line showing Rs 60,000 fixed cost parallel to the
horizontal axis.
3. Determine the variable portion of costs at two volumes of scales (beginning and
ending): 6,000 units × Rs 5 = Rs 30,000; 20,000 units × Rs 5 = Rs 1,00,000.
4. Variable costs are to be added to fixed costs (Rs 30,000 + Rs 60,000 = Rs 90,000).
Plot the point at 6,000 units sales volume and Rs 1,00,000 + Rs 60,000 = Rs
1,60,000. Point is to be plotted at 20,000 units sales volume. This obviously is the
total cost line.
5. The point of intersection of the total cost line and sales line is the BEP. To the right
of BEP, there is a profit area and to the left of it, there is a loss area.
6. Verification: FC ÷ CM per unit = Rs 60,000 ÷ Rs 5 per unit = 12,000 units or Rs
1,20,000
Figure 1 has been drawn using different scales for the horizontal and
vertical axis. Figure 2 has been drawn on a uniform scale for both axes.
Since the scales are the same, the 45° line will always be the proxy of the
sales line. Any amount of sales revenue on the horizontal axis will
correspond to costs and revenue on the vertical axis. Let us illustrate
taking two sales levels.
1. Rs 60,000: FC = Rs 60,000
VC = 30,000 (50 per cent variable cost to volume ratio)
TC = 90,000
Loss = 30,000 (TC, Rs 90,000 – Rs 30,000, sales revenue)
Thus, Rs 60,000 = Rs 60,000 + Rs 30,000 – Rs 30,000. Point A in Figure 2
clearly shows these three relevant figures at the sales volume of Rs 60,000.
2. Rs 1,80,000: FC = Rs 60,000
VC = 90,000
TC = 1,50,000
Profit = 30,000
Thus, Rs 1,80,000 = Rs 60,000 (FC) + Rs 90,000 (VC) + Rs 30,000 (Profit).
Point B in Figure 2 portrays these three relevant figures at the sales volume
of Rs 1,80,000.
Figure 2: Volume-Cost-Profit Graph, Same Scale
The VCP graph in Figure 3 is drawn with the details of the individual segment
of variable cost and is more informative. The steps involved in drawing the
graph include an additional step of adding variable costs to the fixed cost.
This is to be repeated four times for four different components: material,
labour, direct expenses and selling expenses. In fact, fixed costs can also be
further split-up into parts. Such a graph provides a bird’s-eye view of the
entire cost structure to the management. By drawing a line perpendicular
from any volume (horizontal axis), the corresponding cost and profit
variables can be ascertained on the vertical axis.
For instance, at 20,000 unit level, following are the various cost figures, as
shown by the VCP graph (line A).

Fixed costs Rs 60,000

Variable costs:  
Material 40,000
Labour 30,000
Direct expenses 20,000
Selling expenses 10,000
Profit before taxes 40,000
Figure 3: Volume-Cost-Profit Graph, Cost-Wise
The VCP graph can be modified to show the changes in the
profitability factors of Example 4, such as,

[Link] in fixed costs (Rs 10,000 both ways)

[Link] in variable costs (20 per cent both ways)

[Link] in selling price (25 per cent both ways).

Table 4 provides a summary of the results due to the above changes.

Only one change is taken at a point of time.
Table 4
Variable Effect on BEP Margin of safety Operating profit
Fixed costs (Rs 10,000):
Increase Increase (Rs 20,000) Decrease (Rs 20,000) Decrease (Rs 10,000)
Decrease Decrease (Rs 20,000) Increase (Rs 20,000) Increase (Rs 10,000)
(Figure 4)      
Variable costs:      
Increase (to 60 per cent) Increase (Rs 30,000) Decrease (Rs 30,000) Decrease (Rs 18,000)
Decrease (to 40 per cent) Decrease (Rs 20,000) Increase (Rs 20,000) Increase (Rs 18,000)
(Figure 5)      
Selling price (25 per cent):      
Increase Decrease (Rs 20,000) Increase (Rs 20,000) Increase (Rs 18,000)
Decrease Increase (Rs 60,000) Increase (Rs 60,000) Decrease (Rs 30,000)
(Figure 6)
Figure 4: Volume-Cost-Profit Graph, Change in Fixed Cost
 X

Figure 5: Volume-Cost-Profit Graph, Change in Variable Cost

Figure 6:Volume-Cost-Profit Graph, Change in Selling Price
Important Points Regarding Figure 6  
In Figures 4 and 5, there are two cost lines to show the increase and
decrease. But Figure 6, which is designed to reveal the change due to the
selling price, has only one sales line (45°). The impact of change in the
sales price is reflected indirectly in the variable cost line (which is merged
with FC line and is represented by the total cost line). This is due to the fact
that the V/V ratio which is an essential input for drawing the chart gets
changed when the selling price is changed. In other words, Figure 6 is like
Figure 5. The new V/V ratio has been determined as follows.
(1) When there is an increase in selling price by 25 per cent
Sales price ( revised) = Rs 5.50 (Rs 10 + 25 per cent) or 125 per cent (Rs 12.5
per unit).
Variable costs = Rs 5 or 50 per cent (existing).
V/V Ratio = (Rs 5 ÷ Rs 12.50) or (50 ÷ 125) or 40 per cent.
(2) When there is a decrease in sales price by 25 per cent
Sales price= Rs 7.50 (Rs 10 – Rs 2.50) or 75 per cent (Rs 7.5 per unit).
Variable costs= Rs 5 or 50 pr cent (existing).
V/V Ratio= (Rs 5 ÷ Rs 7.50) or (50 ÷ 75) or 66.67 per cent .
Total cost line= Rs 60,000 + 66.67 per cent sales.
Since the V/V ratio assumes a fractional form, care has been taken to plot
points at sales levels of Rs 1,50,000 and Rs 2,40,000 so that corresponding
variable cost figures can be whole numbers, that is, Rs 1,00,000 and Rs
1,60,000 respectively.
Figure 7 portrays VCP relationships of a sales-mix for multi-product firm
(Example 3).
Figure 7: Volume-Cost-Profit Graph, Change in Sales Mix
 Cash Break-Even Point
The VCP relationship can also be used to show the liquidity position of
the firm. This is done through the computation of cash break-even point or
cash break-even sales revenue (CBEP/CBESR). Algebraically:
Total cash fixed cost (CFC)
CBEP = Equation 1
Contribution margin per unit
Total cash fixed cost
CBESR = Equation 2
P/V ratio
Graphically, the CBEP is determined at the point of intersection of total
cash cost line and total sales line. The area to the left of the curve
signifies cash losses and the area on the right side is indicative of cash
profits.
Assuming for Example 4, the cash fixed cost to be Rs 15,000, the CBESR
using Equation 2 would be Rs 30,000 = Rs 15,000 ÷ 0.50
Figure 8 portrays the graphic presentation of the cash break-even sales
revenue.
Figure 8: Cash Break-even Point