Cost Volume Profit (Break-Even) Analysis

1
 Learning Outcomes
• To distinguish between fixed costs and variable costs

• To explore the relationship between volume of activity, income, costs and profit

• To calculate the break-even point

• To consider the limitations of CVP analysis

2
 Cost Classifications
for Predicting Cost Behavior
Considerhow
Consider howaacost
costwill
willreact
reacttotochanges
changesininthe
thelevel
levelofofbusiness
businessactivity.
activity.

Variable
Variablecosts
costs
change
changewhen
whenactivity
activitylevel
levelchanges
changes

3
 Variable Costs
Example:
Material costs for a manufacturing business
- total cost rises with activity level
Material costs

Units of Output
4
 Variable Cost
per Unit

Material cost per unit is constant at different activity levels

Material costs

Units of Output

5
 Cost Classifications
for Predicting Cost Behavior
Considerhow
Consider howaacost
costwill
willreact
reacttotochanges
changesininthe
thelevel
levelofofbusiness
businessactivity.
activity.

Variable
Variablecosts
costs
change
changewhen
whenactivity
activitylevel
levelchanges
changes

Fixed
Fixedcosts
costs
remain
remainunchanged
unchangedwhen
whenactivity
activitychanges.
changes.

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 Fixed Costs
Example:
Rent of premises
Rent Total Rent Costs

Units of Output

7
 Fixed Cost Per Unit
The average rent cost per unit decreases as activity level
increases

Rent Cost per Unit

Units of Output
8
 Cost Classifications - Summary

Behaviour of Cost (within the relevant range)

Cost In Total Per Unit

Total variable cost changes Variable cost per unit remains

Variable as activity level changes. the same over wide ranges
of activity.
Total fixed cost remains Fixed cost per unit goes
Fixed the same even when the down as activity level goes up.
activity level changes.

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 Cost Volume Profit (CVP) Analysis
Example
Wind Bicycles manufactures bikes which it sells for £500 each

Its cost behave as follows:

Variable cost per bike £300

Fixed costs per month £80,000

 Cost-Volume-Profit (CVP) Analysis
Example
WIND BICYCLE CO.
Contribution Profit Statement
For the Month of June
Total Per Unit
Sales (500 bikes) £ 250,000 £ 500
Less: variable expenses 150,000 300
Contribution margin 100,000 £ 200
Less: fixed expenses 80,000
Net income £ 20,000

Contribution Margin (CM)

•The amount remaining from sales revenue after variable costs have been deducted
•Is used to pay fixed costs
•Anything left over is profit 11
 The Contribution Approach

For each additional unit Wind sells, £200 more in contribution margin will help
to cover fixed costs and generate profit.

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The Contribution Approach
Each month Wind must generate at least
£80,000 in total CM to break even.

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 Activity
Calculate how much profit Wind Bicycles will make if it
sells 400 bikes in a month
 Wind Bicycles

If Wind sells 400 bikes in a month, its profit will be

zero. (It will be operating at the break-even point)

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 Break-Even Point

The point where:

total sales revenue = total costs (variable and fixed).

(where total contribution margin equals total fixed costs)

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Sales Volume in Excess of the Break-Even Point
If Wind sells one additional unit (401 bikes),
net profit will increase by £200.
WIND BICYCLE CO.
Contribution Profit Statement
For the Month of June
Total Per Unit
Sales (401 bikes) £ 200,500 £ 500
Less: variable expenses 120,300 300
Contribution margin 80,200 £ 200
Less: fixed expenses 80,000
Net profit £ 200

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 Contribution Margin Ratio

CM Ratio % = Contribution margin x 100

Sales

Wind Bicycles
£200 X 100 = 40%
£500

Each £1 increase in sales will increase contribution margin by £0.40

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 Activity

If sales increase by 100 bicycles, what will be the change in:

• total sales revenue

• contribution margin

• profit

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 Impact of Selling 100 More Bicycles

400
400 Bikes
Bikes 500
500 Bikes
Bikes
Sales
Sales ££200,000
200,000 ££250,000
250,000
Less:
Less: variable
variable expenses
expenses 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin 80,000
80,000 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000
Net
Net profit
profit ££ -- ££ 20,000
20,000

A £50,000 increase in sales revenue

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 Impact of Selling 100 More Bicycles

400
400 Bikes
Bikes 500
500 Bikes
Bikes
Sales
Sales ££200,000
200,000 ££250,000
250,000
Less:
Less: variable
variable expenses
expenses 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin 80,000
80,000 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000
Net
Net profit
profit ££ -- ££ 20,000
20,000

A £20,000 increase in contribution margin

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 Impact of Selling 100 More Bicycles

400
400 Bikes
Bikes 500
500 Bikes
Bikes
Sales
Sales ££200,000
200,000 ££250,000
250,000
Less:
Less: variable
variable expenses
expenses 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin 80,000
80,000 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000
Net
Net profit
profit ££ -- ££ 20,000
20,000

A £20,000 increase in profit

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 Break-Even Point

Break even point = Total Fixed Costs .

Contribution Margin per Unit

Wind Bicycles
= £80,000
£200

= 400 bikes
 Break-Even Point
Alternative Calculation
Break even point = Total Fixed Costs .

(in sales revenue) Contribution Margin Ratio

Wind Bicycles
= £80,000
£0.40

= £200,000 sales revenue

Number of bikes to break-even = £200,000 .

£500 per bike

= 400 bikes
 Cost Volume Profit Graph
450,000

400,000

350,000

300,000 Total Sales

pounds
250,000

200,000

150,000

100,000

50,000

-
- 100 200 300 400 500 600 700 800

Units
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 Cost Volume Profit Graph
450,000

400,000

350,000

300,000
Total costs
pounds
250,000

200,000

150,000
Fixed costs

100,000

50,000

-
- 100 200 300 400 500 600 700 800

Units
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 Cost Volume Profit Graph
450,000

400,000

350,000
A rea
300,000
ro fit
P
pounds 250,000

200,000
Break-even point
150,000

100,000 e a
A r
os s
50,000 L
-
- 100 200 300 400 500 600 700 800

Units

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 Sales Required to Generate a Target Profit

= Total Fixed Costs + Target Profit

. Contribution Margin per Unit
 Sales Required to
Generate a Target Profit
Activity
How many bikes must Wind Bicycles sell to earn a profit of £100,000?

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 Wind Bicycles
Sales Required to Generate £100,000 Profit

= Total Fixed Costs + Target Profit .

Contribution Margin per Unit

= £80,000 + £100,000
£200

= 900 bikes
 The Margin of Safety

Margin of Safety
= Actual sales* - Break-even sales

The amount by which sales can drop before losses are incurred

*can also use planned sales

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 Margin of Safety
Wind Bicycles
Margin of safety = Actual sales - Break-even sales
= 500 bikes - 400 bikes
= 100 bikes
Break-even
Break-even
sales
sales Actual
Actual sales
sales
400
400 units
units 500
500 units
units
Sales
Sales ££ 200,000
200,000 ££ 250,000
250,000
Less:
Less: variable
variable expenses
expenses 120,000
120,000 150,000
150,000
Contribution
Contribution margin
margin 80,000
80,000 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000 80,000
80,000
Net
Net profit
profit ££ -- ££ 20,000
20,000
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 Operating Leverage
A measure of how sensitive net profit is to changes in sales

Degree of Operating Leverage

= Contribution margin
Net profit

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 Wind Bicycles - Operating Leverage
= Contribution margin
Net profit

= £100,000 = 5
£20,000

Actual
Actual sales
sales
500
500 Bikes
Bikes
Sales
Sales ££ 250,000
250,000
Less:
Less: variable
variable expenses
expenses 150,000
150,000
Contribution
Contribution margin
margin 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000
Net
Net profit
profit ££ 20,000
20,000
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Wind Bicycles - Operating Leverage
• Operating leverage = 5

• If sales increases by 10%, profit would increase by 50%

Percent increase in sales 10%

Degree of operating leverage × 5
Percent increase in profits 50%

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 Proof – Wind Bicycles
Activity
Calculate the profit arising from a 10% increase in sales

Actual
Actual sales
sales
500
500 Bikes
Bikes
Sales
Sales ££ 250,000
250,000
Less:
Less: variable
variable expenses
expenses 150,000
150,000
Contribution
Contribution margin
margin 100,000
100,000
Less:
Less: fixed
fixed expenses
expenses 80,000
80,000
Net
Net profit
profit ££ 20,000
20,000

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 Wind Bicycles

10% increase in sales (from

£250,000 to £275,000) . . .
. . . results in a 50% increase in
profit (from £20,000 to £30,000)
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 Operating Leverage

High Leverage (E.g. Wind Bicycles)

A small percentage increase in sales can produce a much larger percentage increase in net profit

Low Leverage
A large percentage increase in sales can produce a much smaller percentage increase in net profit

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 Assumptions of CVP Analysis
• Selling price is constant throughout the entire relevant range.

• Costs are linear throughout the entire relevant range

i.e. - variable cost per unit is constant
- total fixed costs are constant

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 Stepped Costs

Volume 40
 Stepped Costs with Variable Costs

Volume 41
 Total costs
(with stepped costs)

Volume 42
 Total costs
Sales
£

Volume 43
 C

Sales
£
A

Total costs

More than one

break even point

Volume 44
 Sales
£

Total costs

Profit

Volume 45
 Sales
£

Total costs

Loss

Volume 46
 Assumptions of CVP Analysis
• Selling price is constant throughout the entire relevant range.

• Costs are linear throughout the entire relevant range

i.e. - variable cost per unit is constant
- total fixed costs are constant

• In manufacturing companies, stocks do not change

(units produced = units sold)
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