Chapter 18

Cost volume profit analysis

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 Outline
• CVP analysis and the break-even point
• Graphing CVP relationships
• Target net profit
• CVP analysis for management decisions
• CVP analysis with multiple products
• Including income taxes in CVP analysis
• Assumptions underlying CVP analysis
• An activity-based approach to CVP analysis
• Financial planning models
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 What is cost volume profit
(CVP) analysis?
• Determines the effect of changes in an
organisation’s sales volume on its
costs, revenue and profit
• Provides answers to a series of short-
term changes – can determine the
impact on revenue and costs quickly
• Can be used in both profit-seeking and
not-for-profit organisations

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 The break-even point
• The volume of sales where the total revenues
and costs are equal, and the operation breaks
even
• At this level of sales, there is no profit or loss
• The break-even point can be calculated for an
entire organisation or for individual projects or
activities

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 Break-even formulas
Fixed costs
Break-even point (in units) =
Unit contribution margin

Fixed costs
Break-even point (in sales dollars) =
Unit contribution margin ratio

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 Terminology

• Contribution margin (or variable

costing) statement
• Total contribution margin
• Unit contribution margin
• Contribution margin ratio
• Contribution margin percentage

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 Graphing cost volume
profit relationships
• Shows how costs, revenue and profits
change as sales volume changes
• Five steps
– Draw the axes of the graph
– Draw the fixed cost line
– Draw the total cost line
– Draw the total revenue line
– Break-even point – where the total
revenue and total cost lines intersect
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 Cost volume profit graph, Melbourne
Theatre Company production Calypso

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 Profit volume (PV) graph
• Shows the total amount of profit or loss at
different sales volumes
• The graph intercepts the vertical axis at the
amount equal to the fixed costs
• The break-even point is the point at which the
total profit/loss line crosses the horizontal axis

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 Profit volume graph, Melbourne
Theatre Company production Calypso

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 Target net profit
• A desired profit level determined by
management
• The break-even formula can be used
to determine the sales volume
needed to achieve a particular target
profit
Fixed costs + target net profit
Target sales volume (in units) =
Unit contribution margin
Fixed costs + target net profit
Target sales volume (in dollars) =
Unit contribution ratio

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 Using CVP analysis for
management decision making
• Safety margin
– Difference between the budgeted sales
revenue and break-even sales revenue
• Changes in fixed costs
– Percentage change in fixed costs will
lead to a similar increase in the break-
even point (in units or dollars)
• Changes in the contribution margin
per unit
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Multiple changes in key variables
• May involve, for example
– Decreasing variable costs per unit
– Increasing selling prices
– Undertaking a new advertising campaign
– Leasing a new office
• An incremental approach to analysis
– Focuses on the differences in the total
contribution margin, fixed costs and
profits under the two alternatives

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 CVP analysis with multiple
products
• Sales mix
− The relative proportions of each type of product
sold by the organisation
• Weighted average unit contribution margin
− The average of the products’ unit contribution
margins, weighted by the sales mix
Fixed costs
Break-even point =
Weighted average unit contribution margin

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 Profit volume graph with multiple
products, Melbourne Theatre
Company production Calypso

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Including income taxes in CVP
analysis
Sales volume required to earn net
profit after tax

Fixed costs + target net profit after tax

=
(1 – t)
unit contribution margin

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 Assumptions underlying
CVP analysis
• The behaviour of total revenue is linear
• The behaviour of total costs is linear over a
relevant range
• For both variable and fixed costs, sales
volume is the only cost driver
• The sales mix remains constant over the
relevant range
• In manufacturing firms, the levels of inventory
at the beginning and end of the period are the
same
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 CVP analysis and
longer-term decisions
• CVP analysis is usually regarded as a
short-term or tactical decision tool
• Classification of costs as variable or
fixed is usually based on cost
behaviour over the short term
• The financial impact of long-term
decisions is best analysed using
capital budgeting techniques
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 Treating CVP analysis
with caution
• CVP analysis is a simplified model
• The usefulness of CVP analysis may be
greater in less complex, smaller firms, or for
stand-alone projects
• For larger, more complex firms, CVP analysis
can also be valuable as a decision tool for the
planning stages of new projects and ventures

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 An activity-based approach
to CVP analysis

• ABC categorises activities at unit,

batch, product or facility level
– Batch, product and facility activities are
non-volume related activity costs
Total batch, product and facility level costs
Break-even point =
Selling price per unit - costs per unit

(cont.)

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An activity-based approach to CVP
analysis (cont.)

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 Planned activities and costs,
AccuTime Pty Ltd

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 Limiting assumptions of
CVP analysis using
activity-based costs
• Total batch level costs are dependent
on the batch size and the break-
even/target production level
• Management may change the batch
size at certain production volume levels
• More complex models are needed
where there are multiple products
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 Including customer-related
costs in CVP analysis
Profit = Sales revenue – (unit level costs + batch level costs
+ product level costs
+ order level costs
+ customer level costs
+ marketing level costs
+ facility level costs)

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 Financial planning models
• Sensitivity analysis and CVP analysis
• Can be run using spreadsheet software
• Goal seek approaches
– The analyst specifies the outcome, and the
software specifies the necessary inputs
• What-if analysis
– The analyst specifies changes in
assumptions and data to examine the effect
of these changes on the outputs

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 Profit model for AccuTime Pty Ltd
under activity-based costing

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 Summary
• CVP analysis is a decision tool
• The break-even point is the sales level at
which sales cover costs – there is zero profit
• The break-even formula can be modified to
calculate target profit
• CVP analysis has several assumptions which
limit its usefulness for decision making
• Activity-based approaches and financial
planning modelling can provide more
sophisticated models

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