ODPS - C

COST-VOLUME-PROFIT ANALYSIS

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 What is CVP Analysis?
 Cost-Volume-Profit (CVP) analysis is the
study of the effects that changes in FC, VC,
SP, quantity and Mix have on a Company’s
future profits
 In effect we now superimpose (sales) revenue
function onto the (total) cost functions
previously described in topic three

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 Uses of CVP Analysis
 Managers can use CVP analysis for
short-term planning purposes
 Pricing setting
 Determining the quantity sufficient just to
break-even
 Ascertaining the output level required to
earn a certain target profit
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 Uses of CVP Analysis Cont…
 Determining the most profitable
combination of different products
(sales mix)
 Know the extent to which the level of
activity have to fall before the
company finds itself in a loss-making
situation
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 Patterns of Cost Behaviour
 Remember! the classification of costs
(i.e. variable, fixed or semi-fixed)
according to the way they respond to
changes in activity can only be valid
over short-time periods.

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 Variable Costs
 Assuming a linear relationship exist

cost
Y = bx

Volume
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 Fixed Overheads
cost

FC Y=a

Volume

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 Total Costs
cost
Total Cost; Y= a + bx

VC

FC

Volume

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 Sales Revenue
Tshs TR = px

Volume

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 Costs, Contribution and Profit
 In cost-volume-profit (CVP) analysis
costs need to be classified as variable
costs or fixed costs.
 Thus semi-variable costs are divided into
their two components
 Selling price is normally set to cover all
the variable costs of a product.

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 Costs, Contribution and Profit Cont…
 The difference between the selling price and
the unit variable cost is known as
Contribution. This is the money available to
pay off the fixed costs.
 Contribution = SP – VC
 It follows that the difference between the
Sales Income and the variable costs of the
units sold is the total contribution
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Costs, Contribution and Profit cont…
 A business can work out its profit from the
fixed costs and total contribution figures
 Profit = Total contr. – fixed costs
Sales
Less: Variable costs
Equals: Contribution
Less: Fixed costs
Equals: Profit
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 Break Even Analysis
 The break-even point (BEP) for a business is
the output level (units produced or service
provided)
 at which the income from sales is just enough
to cover all the costs.
 Break-even, therefore, is the point at which
the profit/loss is zero (fixed overhead = total
contribution or TC = TR).
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 EFFECT OF CHANGES IN
VOLUME OF SALES – FLEXIBLE BUDGETING
 A Simple Example:
 Selling Price £10
 Variable Cost per unit £6
 Fixed Overhead pa £5,000

Sales Volume (units) 1,000 1,200 1,400

£ £ £
Sales Revenue 10,000 12,000 14,000
Variable Cost (6,000) (7,200) (8,400)
Contribution 4,000 4,800 5,600
Fixed Overhead (5,000) (5,000) (5,000)
Net Profit/(Loss) (1,000) (200) 600
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 Calculation of BEP (volume)
 Recall the total cost equation; Y = a + bx. Also TR
= selling price x volume = px
 As the BEP is where TR = TC, then
px = a + bx
 Alternatively, you can use the following simple
formula
Fixed Cost
BEP (volume) 
Unit contribution

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 Calculation of BEP sales Value
Approach I
TFC  sp
BEP (sales) 
unit contribution
Approach II - (total formula)
TFC  TR
BEP (sales) 
Total contribution
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 Target Profit level
 The BEP formulaic approach can be used to plan,
say, a minimum target profit “P” to be reached by
the business in the coming year.
 Simple addition of the target figure to the fixed cost
numerator of the BEP formula will provide the
activity level needed to achieve the target, thus:
TFC  Target P
Volume needed 
Unit contributi on
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The conventional break-even Charts
 Break-even calculations can also be
demonstrated by a break-even chart.
 The horizontal axis measures output
 The vertical axis represents income and costs
 The fixed cost line is a horizontal line at “a”
level. Since fixed costs will remain the same no
matter how many units are produced

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 The conventional break-even Charts
Cont…
TR
TSHS

Profit
TC

FC
Loss

VOLUME
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 The conventional break-even Charts
Cont…
Tshs TR

TC
Profit

Loss FC
Margin
of
Safety

P BEP Q Volume
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Profit-Volume Graph
Profit

0
Volume

Loss

Unlike the BEP charts, the P/V chart provides mgt with a simpler and
more exact picture of the P/L that arise from decisions to operate at different
levels of volume.

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 Profit-Volume Graph Cont…
P =TR - TC
Profit

Profit
0
Loss
FC Volume
BEP

Contribution to FC
Loss

At zero volume the loss is equivalent to the firm’s fixed overheads

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 Profit-Volume (P/V) Ratio
 The sloping line in the above graph shows the
contribution of each unit towards profits.
 So the steeper the, slope the higher the rate of
contribution (and vice-versa).

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 Profit-Volume (P/V) Ratio Cont…
 The P/V ratio measures the relationship between
contribution and sales.

Contribution per unit

P/V ratio 
Selling price per unit
OR
Total contribution

Sales Revenue
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 Other Formulae
 BEP (sales) – Approach III
Fixed Overheads

P/V ratio
Fixed Overheads

 Contributi on per unit 
 
 Selling price per unit 
Fixed Overheads
  SP
Contributi on per unit
 BEP (Units)  SP
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 Other Formulae Cont…
 Margin of Safety:
how far can sales fall from their current volume
before the firm breaks even
 It can be expressed in terms of Units, Tshs and
percentage

MS  Current Volume - BEP Volume

Current Volume - BEP Volume
%MS 
Current Volume
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 Limitations/Assumption of CVP Analysis
 Though it’s a useful technique for decision-making
activities, CVP analysis needs to be considered in
the light of its limitations:
 Constant fixed costs over the relevant range of activity
 Variable/fixed cost components have been accurately
determined and segregated from each other
 Volume as the only independent variable
 Both costs and revenues behave in a linear fashion
 Production equals sales (i.e. little or no change between
opening and closing stock balances
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 Limitations/Assumption of CVP Analysis
Cont…
 Single product analysis – or if not, then a constant
product sales mix applies
Illustration:
 Abood soap industries sell two products, Tausi
and Komoa, and the budgeted sales are divided
equally between them. The estimated
contribution is Tshs 120/- per Tausi and Tshs 80/-
per Komoa. An analysis of the actual sales for
the period indicated that 75% were for Komoa
and the remaining were for Tausi.
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 Limitations/Assumption of CVP Analysis
Cont…
 What are the break-even points for
budgeted and actual sales if the annual
fixed costs are Tshs 1,800,000/-?
Assume that actual costs and selling
prices are identical to the budget.

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 Non-linear/Curvilinear Revenue Functions
 All graphs above show TR function as an
ever-increasing straight line over the scale of
activity – implying a constant selling price!
What is the maximum profit then?? Never
attained!!!
 The lower the price …! So in order to sell
higher volumes, SP may need to fall.
 This of course may reduce the TR by actually
selling more – Practical?
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Non-linear/Curvilinear Revenue Functions
Cont…
 A multiple break-even point chart – make it
feasible to determine an optimal profit point
other than merely at the top end of the activity
Optimal
range Profit
Tshs
Y Loss

Profit
Z

Loss BEP

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Q Units 31