Study Unit 6

Cost Volume Profit Analysis

Oarabile Manyaapelo CA(SA) RA

 Cost-Volume-Profit (CVP) Analysis
CVP analysis helps managers understand the interrelationship
between cost, volume and profit in an organization by focusing on
interactions between five variables:
• Prices of products
• Volume or level of activity
• Per unit variable costs
• Total fixed costs
• Mix of products sold.

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

Contribution Margin (CM) is the amount remaining from

sales revenue after variable expenses have been deducted.
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The Basics of Cost-Volume-Profit (CVP) Analysis
WIND BICYCLE CO.
Contribution Profit Statement
For the Month of June
Total Per Unit
Sales (500 bikes) R 250 000 R 500
Less: variable expenses 150 000 300
Contribution margin 100 000 R 200
Less: fixed expenses 80 000
Net income R 20 000

CM goes to cover fixed expenses.

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

After covering fixed costs, any remaining CM

contributes to profit.
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The Contribution Approach
For each additional unit Wind sells, R200
more in contribution margin will help to
cover fixed expenses or profit

Total Per Unit Percent

Sales (500 bikes) R 250 000 R 500 100%
Less: variable expenses 150 000 300 60%
Contribution margin R 100 000 R 200 40%
Less: fixed expenses 80 000
Net profit R 20 000

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The Contribution Approach
Total Per Unit Percent
Sales (500 bikes) R 250 000 R 500 100%
Less: variable expenses 150 000 300 60%
Contribution margin R 100 000 R 200 40%
Less: fixed expenses 80 000
Net profit R 20 000

Each month Wind must generate at least R80 000 in total CM

to break even.
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The Contribution Approach
Total Per Unit Percent
Sales (500 bikes) R 250 000 R 500 100%
Less: variable expenses 150 000 300 60%
Contribution margin R 100 000 R 200 40%
Less: fixed expenses 80 000
Net profit R 20 000

For each additional unit Wind sells, R200 more in contribution

margin will help to cover fixed expenses or profit.

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 The Contribution Approach
WIND BICYCLE CO.
Contribution Profit Statement
For the Month of June
Total Per Unit
Sales (400 bikes) R 200 000 R 500
Less: variable expenses 120 000 300
Contribution margin R 80 000 R 200
Less: fixed expenses 80 000
Net profit R 0

If Wind sells 400 units in a month, it will be operating at

the break-even point.

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The Contribution Approach
WIND BICYCLE CO.
Contribution Profit Statement
For the Month of June
Total Per Unit
Sales (400 bikes) R 200 000 R 500
Less: variable expenses 120 000 300
Contribution margin R 80 000 R 200
Less: fixed expenses 80 000
Net profit R 0

If Wind sells 400 units in a month, it will be

operating at the break-even point.

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The Contribution Approach
WIND BICYCLE CO.
Contribution Profit Statement
For the Month of June
Total Per Unit
Sales (401 bikes) R 200 500 R 500
Less: variable expenses 120 300 300
Contribution margin 80 200 R 200
Less: fixed expenses 80 000
Net profit R 200

If Wind sells one additional unit (401 bikes), net profit will
increase by R200.
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The Contribution Approach
The break-even point can be defined either as:
 The point where total sales revenue equals total
expenses (variable and fixed).
 The point where total contribution margin equals total
fixed expenses.

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Contribution Margin Ratio

The contribution margin ratio is:

CM Ratio = Contribution margin

Sales
For Wind Bicycle Co. the ratio is:

R200
= 0 ,4 or 40%
R500
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Contribution Margin Ratio

At Wind, each R1,00 increase in sales

revenue results in a total contribution
margin increase of 40 cents.

If sales increase by R50 000, what will

be the increase in total contribution
margin?

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 Contribution Margin Ratio
400
400 Bikes
Bikes 500
500 Bikes
Bikes
Sales
Sales RR 200
200 000
000 RR 250
250 000
000
Less:
Less: variable
variable expenses
expenses 120
120 000
000 150
150 000
000
Contribution
Contribution margin
margin 80
80 000
000 100
100 000
000
Less:
Less: fixed
fixed expenses
expenses 80
80 000
000 80
80 000
000
Net
Net Profit
Profit RR -- RR 20
20 000
000

R20 000 increase in contribution margin. R50 000 increase in

40% Contribution Margin on R50 000 sales sales revenue

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Changes in Fixed Costs and Sales Volume

Wind is currently selling 500 bikes per month. The company’s

sales manager believes that an increase of R10 000 in the
monthly advertising budget would increase bike sales to 540
units.

 Should we authorise the requested increase in the

advertising budget?

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Changes in Fixed Costs and Sales Volume
40 additional
units

Current
Current Sales
Sales Projected
Projected Sales
Sales
(500
(500 bikes)
bikes) (540
(540 bikes)
bikes)
Sales
Sales RR 250
250 000
000 RR 270
270 000
000
Less:
Less: variable
variable expenses
expenses 150
150 000
000 162
162 000
000
Contribution
Contribution margin
margin 100
100 000
000 108
108 000
000
Less:
Less: fixed
fixed expenses
expenses 80
80 000
000 90
90 000
000
Net
Net profit
profit RR 20
20 000
000 RR 18
18 000
000

Sales increased by R20 000 but net profit Fixed cost

decreased by R2 000 increased by
R10 000
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Changes in Fixed Costs and Sales Volume

The Shortcut Solution

Increase in CM (40 units X R200) R 8 000

Increase in advertising expenses 10 000
Decrease in net profit -R 2 000

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Changes in Variable Costs and Sales Volume

Wind is contemplating the use of higher-quality components,

which would increase variable costs (and thereby reduce the
contribution margin) by R20 per bike. However, the sales
manager predicts that the higher overall quality would increase
sales to 550 bikes per month.

Should the higher-quality components be used?

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Changes in Variable Costs and Sales Volume

The Shortcut Solution (New CM=R180

CM Decrease (500 units X R20) R 10 000

CM Increase (new sales of 50 units) 9 000
Decrease in net profit R 1 000

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 Break-Even Analysis
Break-even analysis can be
approached in two ways:
 Equation method.
 Contribution margin
method.

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 Equation Method
Profits = Sales – (Variable expenses + Fixed expenses)

OR

Sales = Variable expenses + Fixed expenses + Profits

At the break-even point

profits equal zero.
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 Total
Total Per
PerUnit
Unit Percent
Percent
Sales
Sales(500
(500bikes)
bikes) RR 250
250000
000 RR 500
500 100%
100%
Less:
Less:variable
variableexpenses
expenses 150
150000
000 300
300 60%
60%
Contribution
Contributionmargin
margin RR 100
100000
000 RR 200
200 40%
40%
Less:
Less:fixed
fixedexpenses
expenses 80
80000
000
Net
Netprofit
profit RR 2020000
000

Here is the information from Wind Bicycle Co.:

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 Equation Method

We calculate the break-even point as follows:
Sales = Variable expenses + Fixed expenses + Profits

R500Q = R300Q + R80,000 + R0

Where:
Q = Number of bikes sold
R500 = Unit sales price
R300 = Unit variable expenses
R80 000 = Total fixed expenses

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 Equation Method


We can also use the following equation to compute the break-even point in
sales.
Sales = Variable expenses + Fixed expenses + Profits

X = 0,60X + R80 000 + R0

Where:
X = Total sales
0,60 = Variable expenses as a percentage of sales
R80 000 = Total fixed expenses

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 Equation Method

We can also use the following equation to compute the break-even
point in sales.

Sales = Variable expenses + Fixed expenses + Profits

X = 0,60X + R80 000 + R0

0,40X = R80 000

X = R200 000

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Contribution Margin Method
The contribution margin method is a
variation of the equation method.
Break-even point Fixed expenses
in units sold = Unit contribution margin

Break-even point in
Fixed expenses
total sales = CM ratio

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 CVP Relationships in Graphic Form
Viewing CVP relationships in a graph gives managers a perspective that
can be obtained in no other way. Consider the following information for
Wind Co.:

Profit
Profit Profit
Profit Profit
Profit
300
300 units
units 400
400 units
units 500
500 units
units
Sales
Sales RR 150
150 000
000 R
R 200
200 000
000 R
R 250
250 000
000
Less:
Less: variable
variable expenses
expenses 90
90 000
000 120
120 000
000 150
150 000
000
Contribution
Contribution margin
margin RR 60 60 000
000 R
R 8080 000
000 R
R 100
100 000
000
Less:
Less: fixed
fixed expenses
expenses 80
80 000
000 80
80 000
000 80
80 000
000
Net
Net profit
profit (loss)
(loss) -R
-R 20 20 000
000 R
R -- R
R 2020 000
000

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450,000
Total sales
400,000

350,000
r ea
it A Total Cost
o f
Pr
300,000

250,000

200,000

150,000
Break even
point
100,000 r ea
A
50,000 o ss
L
- Fixed cost
- 100 200 300 400 500 600 700 800

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Target Profit Analysis

Suppose Wind Co. wants to know how

many bikes must be sold to earn a profit
of R100 000.

We can use our CVP formula to

determine the sales volume needed to
achieve a target net profit figure.

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 The CVP Equation
Sales = Variable expenses + Fixed expenses + Profits

R500Q = R300Q + R80 000 + R100 000

R200Q = R180 000

Q = 900 bikes

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The Contribution Margin Approach

We can determine the number of bikes that must be sold to

earn a profit of R100 000 using the contribution margin
approach.

Units sold to attain Fixed expenses + Target profit

the target profit = Unit contribution margin

R80 000 + R100 000

= 900 bikes
R200

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 The Margin of Safety
Excess of budgeted (or actual) sales over the break-even volume of
sales. The amount by which sales can drop before losses begin to
be incurred.

Margin of safety = Total sales - Break-even sales

Let’s calculate the margin of safety for Wind.

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 The Margin of Safety
Wind has a break-even point of R200 000. If actual sales are
R250 000, the margin of safety is R50 000 or 100 bikes.

Break-even
Break-even
sales
sales Actual
Actual sales
sales
400
400 units
units 500 units
500 units
Sales
Sales R
R 200
200 000
000 RR 250
250 000
000
Less:
Less: variable
variable expenses
expenses 120
120 000
000 150
150 000
000
Contribution
Contribution margin
margin 80
80 000
000 100
100 000
000
Less:
Less: fixed
fixed expenses
expenses 80
80 000
000 80
80 000
000
Net
Net profit
profit R
R -- RR 2020 000
000

The margin of safety can also be expressed as 20% of sales

(R50 000/R250 000)
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 Operating Leverage
• A measure of how sensitive net profit is to percentage changes
in sales.

• With high leverage, a small percentage increase in sales can

produce a much larger percentage increase in net profit.
Degree of Contribution margin
operating leverage = Net profit

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

R100 000 = 5
R20 000
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 Operating Leverage
With a measure of operating leverage of 5, if Wind increases its
sales by 10%, net profit would increase by 50%.

Percent increase in sales 10%

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

Here’s the proof!

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 Operating Leverage
Actual sales Increased
(500) sales (550)
Sales R 250 000 R 275 000
Less variable expenses 150 000 165 000
Contribution margin 100 000 110 000
Less fixed expenses 80 000 80 000
Net profit R 20 000 R 30 000

10%
10% increase
increase in
in sales
sales from
from .. .. .. results
results in
in aa 50%
50% increase
increase in
in
R250
R250 000
000 to
to R275
R275 000
000 .. .. .. profit
profit fromfrom R20
R20 000
000 to
to R30
R30 000.
000.

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Automation from a CVP perspective

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Automation from a CVP perspective

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 The Concept of Sales Mix
• Sales mix is the relative proportions in which a
company’s products are sold.
• Different products have different selling prices,
cost structures, and contribution margins.
• Changes in the sales mix can cause interesting
(and sometimes confusing) variations in a
company’s profits.
Let’s assume Wind sells bikes and carts and see
how we deal with break-even analysis.
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 The Concept of Sales Mix
Wind Bicycle Co. provides us with the following information:

Bikes Carts Total

Sales R 250 000 100% R 300 000 100% R 550 000 100%
Var. exp. 150 000 60% 135 000 45% 285 000 52%
Contrib. margin R 100 000 40% R 165 000 55% 265 000 48%
Fixed exp. 170 000
Net profit R 95 000

R265 000
Overall Contribution Margin Ratio = 48% (rounded)
R550 000
R170 000
0,48 = R354 167 (rounded)
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 The Concept of Sales Mix
Bikes Carts Total
Sales R 250 000 100% R 300 000 100% R 550 000 100%
Var. exp. 150 000 60% 135 000 45% 285 000 52%
Contrib. margin R 100 000 40% R 165 000 55% 265 000 48%
Fixed exp. 170 000
Net profit R 95 000

Weighted Sales: Bikes = 250 000 / 550 000 = 0.46

Carts = 300 000 / 550 000 = 0.54

Bikes: R354 167 x 0,46 = 162 917

Carts: R354 167 x 0,54 = 191 250
Break even sales mix

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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.
In multi-product companies, the sales
mix is constant.
In manufacturing companies, stocks do
not change (units produced = units
sold).

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