SESSION 6

CVP ANALYSIS
Session’s Learning Objectives

1.Concept and relationship of cost, volume and profit.

2.Uses of cost–volume–profit (CVP) analysis in business decisions.
3.Measurement of break-even (BE) level.
4.Concept of margin of safety and its utility in business decisions.
5.Uses and limitations of CVP analysis.
 Cost-Volume-Profit Analysis
• Cost-volume-profit (CVP) analysis is a
– method of cost accounting
– that looks at the impact
– that varying levels of costs and volume
– have on operating profit. 
 Cost-Volume-Profit Analysis
Assumptions
• Sales price and Variable cost per unit are constant.
• Total fixed costs are constant.
• Profits are calculated on a variable costing basis.
• costs will behave in the same manner within
the relevant range. The relevant range represents the
activity level where the company reasonably expects to
operate during a particular period of time. It is also
referred to as the normal or practical range.
• Everything produced is sold.
• Costs are only affected because activity changes.
• If a company sells more than one product, they are sold
in the same mix.
 CVP Scenario
Per Unit Percentage of Sales
Selling price (trip ) £250 100%
Variable cost (fuel) 200 80
CONTRIBUTION (S.P-V.C) £ 50 20%
Monthly fixed expenses:
Rent £2,500
Driver’s Salary 3,500
Car Maintenance 1,000
Total fixed expenses per month £ 6,500
 P/V RATIO (PROFIT VOLUME
RATIO)
• When Single period data is given:
P/V Ratio = (Contribution per unit/S.P. per unit)

• When Comparative or two period data is given:

P/V ratio = (Change in Profit/Change in sales) x 100
Uses of CVP Analysis

1.To forecast profit fairly accurately as all the information and calculations are
known. If a firm wishes to increase or decrease the future profits, it can be
measured through the CVP analysis in a more logical manner.
2.Forecast sales volume to achieve a particular level of profit.
3.To prepare flexible budgets where variable cost alone changes. The flexible
budget is a concept where fixed cost at different levels of production remains
the same and variable cost alone changes.
4.The firm can also evaluate the impact of increased sales volume on profits.
5.Effect on profit if the fixed cost or variable cost changes.
6.Required sales volume to cover additional fixed costs due to higher
investments.
7.Assessment of contribution on account of changes in sales volume.
8.To attain sales level on account of changes in contribution.
9.And so many other business operation-related decisions.
Limitation of CVP Analysis

1.It is presumed in the CVP analysis that variable cost per unit will remain the
same over a certain period of time but this may not be true.
2.Even certain components of fixed cost will vary if output increases at a
certain level within the available capacity.
3.Variable cost per unit may change if firm changes the procurement policy.
4.Selling price may vary due to various internal and external factors. The firm
may change its discount policy on sale.
5.The production process may become more efficient. The increased efficiency
will impact the CVP analysis.
6.There is a concept of semi-variable cost in the production process, whereas
the CVP analysis presumes only two costs, namely, variable cost and fixed
cost do exist. It is practically difficult to exactly differentiate between the two.
7.It has to be used carefully if there are mixed products.
 Break-Even Point
The break-even point is the level of sales at
which revenue equals expenses and net income
is zero.
Sales
- Variable expenses
- Fixed expenses
Zero net income (break-even point)
Assumption of BE Analysis

1.Selling price is constant at all level of sales. Hence, if plotted it will represent
a straight line.
2.There are only two categories of cost, fixed and variable. If there are costs
which are mixed, for example, semi-fixed cost such as electricity expenses,
then these are to be segregated into fixed and variable.
3.Variable cost per unit is constant.
4.Total fixed cost remains constant.
5.Total production units and sales units are equal.
6.In multi-product scenario, sales mix is to remain constant.
7.There is no change in production technology, efficiency, etc.
Limitation of BE Analysis

1.The BE analysis assumes that revenue and cost are constant and linear in
nature. Thus, these factors are static in nature. However, in actual world these
factors are dynamic in nature.
2.Selling price changes with respect to the quantity of sales, market demand
and price sensitivity. Hence, it does not remain constant.
3.Variable cost may not remain constant and bulk purchase gives discount to a
firm.
4.Fixed cost changes with the changes in certain factors such as capacity
changes.
5.In a multi-product scenario, sales mix may not remain constant.
6.Segregation of mixed cost into variable and fixed costs may be difficult and
therefore results may not be realistic.
 CVP analysis: non-graphical computations
1. Fixed costs per annum £60 000
Unit selling price £20
Unit variable cost £10
Relevant range 4 000 - 12 000 units

2. Profit volume (P/V) ratio = Contribution x 100 = (20-10)/20 x 100 = 50%

Sales revenue
3. Break-even point (in units) = Fixed costs = 60,000/10 = 6000 units
Contribution per unit

4. Break-even point (in sales value i.e. £ ) = Fixed costs

P/V ratio
OR = BEP in units x S.P p.u
= 60,000/50% = £ 120,000
= 6000 * 20 = £ 120,000
4. If unit fixed costs and revenues are not given, the break-even point (expressed in sales
values) can be calculated as follows:

Total fixed costs x Total sales

Total contribution

5. Units to be sold to obtain a desired profit (£30,000 profit):

Fixed costs + desired profit
Contribution per unit =( 60,000+ 30,000) /£10 = 9000 units

6. Sales to obtain a desired profit (£30 000 profit):

Fixed costs + desired profit
=( 60,000+ 30,000) 50%= £180,000
P/V ratio
Margin of Safety

Margin of safety = Expected Sales – Break even sales

OR

Profit
P/V ratio
Cost-Volume-Profit Graph
 Quiz!!!
• UKL plastics make plastic buckets. An analysis of their accounting reveals:
– Variable cost per bucket £ 20
– Fixed cost £ 50,000 for the year
– Capacity 2000 buckets per year
– Selling price per bucket £ 70
• Required:
1. Find the break-even point in £ Sales. £ 70,000
2. Find the number of buckets to be sold to get a profit of £ 30,000 if the S.P is reduced
to £ 60 p.u. 2000 units
3. If the company can manufacture 600 buckets more than their original capacity per
year with an additional fixed cost of £ 2000, what should be the selling price to
maintain the profit per bucket as in original information? £ 65
• (Note: All the three situations are mutually exclusive.)
 Quiz

• Digital Devices produces digital components used in consumer electronic

equipment. Over the past three years, the company has invested heavily in
equipment and research and development. In the current year, sales
increased by 20%. Profit, however, increased by 35%. The large increase in
profit was not due to improvements in cost control. In fact, fixed costs were
close to the level incurred in the previous year.
Why did profit increase by such a large percent?
 Quiz-Solution
• When sales increase by 20%, variable costs
will also increase by 20% (assuming they are
proportional to sales). Fixed costs, however,
are not expected to increase, and thus, total
costs will increase by less than 20%. It should
not be surprising that profit increases by a
greater percent than sales.
 Operating Leverage

Operating leverage: a firm’s ratio of fixed costs to variable costs.

Highly leveraged firms have high fixed costs and low variable costs.
A small change in sales volume = a large change in net income.

Low leveraged firms have lower fixed costs and higher variable costs.
Changes in sales volume will have a smaller effect on net income.
Quiz
Two businesses AB Ltd. CD Ltd. sell same type of product in the same type of
market. Their budgeted profit and loss accounts for the current year ending
are as follows:
Particulars AB Ltd. CD Ltd.
Sales £ 150,000 £ 150,000
Less: Variable costs £ 120,000 £100,000
Fixed costs £ 15,000 £ 135,000 £ 35,000
£135,000
Net Budgeted Profit £15,000 £15,000

You are required to calculate

1.BEP of each business
2.State which business is likely to earn greater profits and why; in the
condition of (a) heavy demand (b) low demand for the product?
Question
Metro Service Ltd. is operating at 70% capacity and presents the following information: Break-
even point : Rs. 200 crore
•P/V Ratio : 40%
•Margin of safety : Rs 50 crore
Metro management has decided to increase production to 95% capacity level with the following
modifications–
• Selling price will be reduced by 8%
•The variable cost will be reduced to 55% on sales.
•The fixed cost will increase by Rs 27 crore including depreciation on additions, but excluding
interest on additional capital.
• Additional capital of Rs. 50 crore will be needed for capital expenditure and working capital.
You are required to calculate
•(i) Sales required to earn Rs.7 crore over and above the present profit and also to meet 20%
interest on additional capital;
•(ii) Revised break-even point;
•(iii) Revised P/V ratio; and
•(iv) Revised margin of safety.