PDE 4232 – Finance - Lecture 7:

Management Accounting :

Cost-Volume-Profit (CVP) Analysis

 Main Points to be discussed:
• Distinguish between fixed costs and variable costs
and use this distinction to explain the relationship
between costs, volume and profit.

• Prepare a break-even chart and deduce the break-

even point for some activity.

• Discuss the weaknesses of break-even analysis.

 CVP Analysis
Fixed and Variable Costs
• A variable cost is one which varies directly with
changes in the level of activity, over a defined
period of time
• A fixed cost is one which is not affected by
changes in the level of activity, over a defined
period of time
 Graph of Total Variable Cost against Activity

Total
Cost

Level of
Activity
 Graph of Total Fixed Cost against Activity
Total
Cost

Level of
Activity
 Graph of Total Costs against Activity

Total
Cost

Variable
-----------

--------
Fixed

Level of
Activity
 Graph of Total Costs & Total Sales against Activity

Total Total Sales

£s (Revenues)

-----------
Variable

--------
Fixed

Level of
Activity
 Definition of Break-Even Point
• The break-even point is that point of activity
(measured as sales volume) where total sales and
total costs are equal, so that there is neither profit
nor loss.
 CVP Analysis
Graph of Total Costs & Total Sales against Activity

Total Total Sales

£s (Revenues)

Break-even
point
Variable
.
--------
Fixed

Level of
Activity
 Definition of Margin of Safety
• The margin of safety is the difference between the break-even
sales and the normal level of sales (measured in units or in £s
of sales).

• Let us assume the following figures:

• Fixed costs = £32,000; Breakeven Point in units & £s = 400

units & £40,000; Actual level of Sales in units & £s = 500
units & £50,000. Based on these figures, the following graph
is drawn:
 Break-Even Chart
Sales Total
Revenues
& Costs
Profit
in £s
Area
Total
50 000 Costs
Margin
of Safety Break-even
in £s point
Total
40 000 . Variable
Costs

32 000
Margin Total
of Safety
Fixed
in units
Costs

Loss 400 500 Units

Area
of Sales
 Break-Even Analysis
• Case study: Market Trader
• A market trader rents a store at a fixed price of £2100
per month and sells a certain product, namely product
“A”.
• The unit of product “A” cost the trader £5 to buy and
has a selling price of £8 each.
• How many units must be sold to break even? Also
how much in £s to break-even?
 Break-Even Point
• Total Revenue = Total Costs

• Total Revenue = Total fixed costs + Total variable costs

• Selling price * units sold = Total fixed costs + (variable costs per unit * units)

• (Selling price * units) – (variable costs per unit * units) = Total fixed costs

• Units (selling price – variable costs per unit) = Total fixed costs

• Therefore:
Total fixed costs
• Break  even point  in units
Selling price – variable costs per unit
Break-Even Point in Units

-------------------------
Total Fixed Costs

-----------------------------
Selling Price – Variable costs per unit
Break-Even Point in Units

-------------------------
Total Fixed Costs

-----------------------------
Contribution per unit
 Contribution Per Unit
• Contribution per unit is the sales price per unit
minus the variable cost per unit.
• It measures the contribution made by each item of
output to the fixed costs and profit of the
organisation.
Break-Even Point in Pounds

Break-Even Point in Units

Multiplied by
Multiplied by

Selling Price Per Unit

 Referring back to the example, the contribution is £3 per unit (selling
price £8 minus variable cost £5) and the fixed costs are £2100.

• Break-even point in units

= £2100
--------- = 700 units
-----------
(£8 - £5)
• Break-even point in pounds
= Break-even units * selling price
---- units * £ --8 = £5600
= 700
• To justify this answer, a contribution income statement as
follows:
Contribution Income Statement
Revenue (selling price * units sold)
£8 * 700 units 5600

Less: Variable Costs (3500)

(Variable costs * units sold)
£5 * 700 tickets

= Contribution Margin 2100

Less: Fixed Costs (2100)

= Operating Profit/Loss Nil

 Using Break-Even Analysis
Break-even analysis may be used to answer questions
such as:
• What level of sales is necessary to cover fixed costs and
make a specified profit?
• What is the effect of contribution per unit beyond the
break-even point?
• What happens to the break-even point when the selling
price changes?
• What happens to the break-even point when the variable
cost per unit changes?
• What happens to the break-even point when the fixed
costs change?
 Break-Even Chart
Sales Total
Revenues
& Costs
Profit
in £s
Area
Total
50 000 Costs
Margin
of Safety Break-even
in £s point
Total
40 000 . Variable
Costs

32 000
Margin Total
of Safety
Fixed
in units
Costs

Loss 400 500 Units

Area
of Sales
 Determining Level of Sales to Cover Fixed Costs and Making
a Profit

= (Total Fixed Costs + Profit Required)

-----------------------------------------------

Contribution Per Unit

 Example
• Selling price per unit £8

• Variable cost per unit £5

• Fixed cost £2100

• Desired level of profit £450

• How much should the company sell to achieve the

desired level of profit of £450?
 Therefore….
= (Total Fixed Costs + Profit Required)
Contribution Per Unit
• Volume of sales required
= £2100 + £450 = £2550
(£8 - £5) £3
• = 850 units and to justify the answer, again a
contribution income statement is prepared as follows:
Contribution Income Statement
Revenues (selling price * units sold)
£8 * 850 units 6800
Less: Variable Costs
(Variable costs * units sold)
£5 * 850 tickets (4250)

= Contribution Margin 2550

Less: Fixed Costs
(2100)
= Operating Profit
450
 Limitations of Break-Even Analysis
• Non-linear relationships: The break-even graphs assume that
cost and revenue behaviour patterns are known and change on a
straight-line basis as activity levels change. It may not always be
feasible to split costs neatly into variable and fixed categories.
Some costs show mixed behaviour.
• Stepped fixed costs: The break-even graphs assume that fixed
costs remain constant over the volume range under consideration.
If that is not the case then the graph of total costs will have a step
in it where the fixed costs are expected to increase.
• Break-even analysis, as described so far in this text, assumes
input & output volumes are the same, so that there is no
build-up of stocks and work-in-progress.
• Break-even charts and simple analyses can only deal with
one product at a time.
 Key Terms
• Cost-Volume-Profit (CVP)
• Breakeven Point
• Margin of Safety
• Contribution Margin
• Contribution Income Statement
• Operating Profit
Review Questions for Seminar 7: Q.1:
• Bon Voyage is a travel agency specialising in flights
between Paris & London. It books passengers on Air
France.

• Ticket price is £100 per passenger. Fixed costs are

£26 000 per month. The variable costs are £35 per
ticket.
 The management of Bon Voyage have
requested the following information:
1. The number of tickets that must be sold to break even
Justify your answer.

2. How many tickets must be sold to earn £6500 profit?

Justify your answer.

3. What is the margin of safety, in units, £s and as a percentage for the level
determined in question 2? (Draw a graph also showing the margin of safety).

4. What selling price would have to be charged to give a profit of

£10 000 on sales of 600 tickets, fixed costs of £ 26 000 and variable costs of
£35 per ticket?

5. How many additional tickets must be sold to cover the extra cost of fixed
advertising of £3 900? (justify your answer).
 Question 2:
• Pilot Ltd. Manufactures and sells pens. Present
sales output is 5 million annually at a selling price
of £0.50 per unit. Fixed costs are £900 000 per
year. Variable costs are £0.30 per unit.
• Required (consider each case separately):
 Case 1
1. What is the present operating profit for a year?
2. What is the present break-even point in
revenues? Justify your answer.
 Case 2
• Calculate the new break-even point in units
for each of the following changes:
1. A 20% increase in fixed costs.
2. A 10% increase in selling price and a £20,000
increase in fixed costs.
 Case 3
• Calculate the new operating profit for each of
the following changes:
1. A £0.04 per unit increase in variable costs.
2. A 20% decrease in fixed costs, a 20% decrease in
selling price, a 10% decrease in variable costs per
unit, and a 40% increase in units sold.