Chapter 7 Cost Volume Profit (CVP) Analysis

1. Objectives
1.1 Explain the nature of CVP analysis.
1.2 Calculate and interpret breakeven point and margin of safety.
1.3 Calculate the contribution to sales ratio in single and multi!product situations and
demonstrate an understanding of its use.
1." Calculate target profit or revenue in single and multi!product situations and
demonstrate an understanding of its use.
1.# Prepare break even charts and profit volume charts and interpret the information
contained $ithin each including multi!product situations
1.% &iscuss the limitations of CVP analysis for planning and decision making.
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+ a r g i n o f
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' r e a k e v e n
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2. A ecap of !asic CVP Analysis for "in#le Pro$uct
65
2.1 !rea%even analysis
2.1.1 &ey 'erms
2a3 Contribution per unit 4 unit selling price 5 unit variable costs
2b3 'reakeven point 4 activity level at $hich there is neither profit nor loss
4
unit per on Contributi
ts fixed Total cos
2c3 Contribution-sales 2C-*3 ratio 4 profit-volume 2P-V3 ratio
4 6 177
Sales
on Contributi
2d3 *ales revenue at breakeven point 4 fixed costs 8 C-* ratio
2e3 +argin of safety 2in units3 4 budgeted sales units 5 breakeven sales units
2f3 +argin of safety 2as 63 'udgeted sales 5 breakeven sales 9 1776
'udgeted sales
2g3 *ales volume to achieve a target profit 1ixed cost : target profit
Contribution per unit
2.1.2 ()ercise 1
( company manufactures a single product $hich has the follo$ing cost structure
based on a production budget of 17777 units.
+aterials 5 " kg at ;3-kg ;12
&irect labour 5 # hours at ;<-hour ;3#
Variable production overheads are recovered at the rate of ;= per direct labour hour.
>ther costs incurred by the company are?
66
;
1actory fixed overheads 127777
*elling and distribution overheads 1%7777
1ixed administration overheads =7777
/he selling and distribution overheads include a variable element due to a distribution
cost of ;2 per unit.
/he fixed selling price of the unit is ;12@.
e*uire$+
2a3 Calculate ho$ many units have to be sold for the company to breakeven.
2b3 Calculate the sales revenue $hich $ould give a net profit of ;"7777.
2c3 Af the company could buy in the units instead of manufacturing them calculate
ho$ much it $ould be prepared to pay if both?
2i3 estimated sales for next year are @#77 units at ;12@ eachB and
2ii3 ;1@<#77 of fixed selling distribution and administrative overheads $ould
still be incurred even if there is no production 2all other fixed overheads
$ould be saved3.
"olution+
67
68
2.2 'he ,raphical Approach for "in#le Pro$uct
2.2.1 /he second $ay to find the break!even is to use the graphical method. /he graphical
method is based on the break!even chart a graphical representation of cost!volume!
profit relationships and the break!even point. At is an attempt to help management in
their understanding of these relationships and so enable them to decide on the
optimum level of output.
2.2.2 ()ample 1
( ne$ product has the follo$ing sales and cost data.
*elling price ;%7 per unit
Variable costs ;"7 per unit
1ixed costs ;2#777 per month
1orecast sales 1=77 units per month
e*uire$+
Prepare a breakeven chart using the above data.
"olution+
69
-. !rea%even Analysis for .ultiple Pro$ucts
-.1 A major assumption
3.1.1 >rganisations typically produce and sell a variety of products and services. /o perform
breakeven analysis in a multi!product organisation ho$ever a constant pro$uct sales
mi) must be assume$. An other $ords $e have to assume that $henever x units of
product ( are sold y units of product ' and C units of product C are also sold.
3.1.2 ()ample 2
P0 produces and sells t$o products. /he + sells for ;< per unit and has a total
variable cost of ;2.@" per unit $hile the D sells for ;1# per unit and has a total
variable cost of ;".# per unit. /he marketing department has estimated that for every
five units of + sold one unit of D $ill be sold. /he organiCationEs fixed costs total
;3%777.
e*uire$+
Calculate the breakeven point for P0.
"olution+
1. Calculate contribution per unit
+ D
; per unit ; per unit
*elling price <.77 1#.77
Variable cost 2.@" ".#7
Contribution ".7% 17.#7
2. Calculate contribution per mix
4 ;".7% x # : ;17.#7 x 1 4 ;37.=7
3. Calculate the breakeven point in terms of the number of mixes
4 fixed costs - contribution per mix
4 ;3%777 - ;37.=7
4 11%@ mixes 2rounded3
". Calculate the breakeven point in terms of the number of units of products
70
4 211%@ x #3 #="# units of + and 211%@ x 13 11%@ units of D
#. Calculate the breakeven point in terms of revenue
4 2#="# x ;<3 : 211%@ x ;1#3
4 ;"7@1# of + and ;1<#3# of D
4 ;#="#7 in total
3.1.3 ()ercise 2
(lpha manufactures and sells three products the beta the gamma and the delta.
.elevant information is as follo$s.
'eta )amma &elta
; per unit ; per unit ; per unit
*elling price 13#.77 1%#.77 227.77
Variable cost <3.#7 #=.@7 1"%.27
/otal fixed costs are ;@#7777.
(n analysis of past trading patterns indicates that the products are sold in the ratio
3?"?#
e*uire$+
Calculate the breakeven point for (lpha.
"olution+
71
-.2 Contribution to sales (C/") ratio for multiple pro$ucts
3.2.1 /he brea%even point in terms of sales revenue can be calculate$ as fi)e$ costs /
avera#e C/" ratio.
3.2.2 (ny change in the proportions of pro$ucts in the mi) $ill chan#e the contribution
per mi) an$ the avera#e C/" ratio and hence the brea%even point.
3.2.3 Fou should kno$ that the C-* ratio is sometimes called the profit/volume ratio or
P/V ratio.
3.2." ()ample -
(s example 2 above $e can calculate the breakeven point of P0 as follo$s.
"olution+
1. Calculate revenue per mi)
4 2# x ;<3 : 21 x ;1#3 4 ;#7
2. Calculate contribution per mi) 2see example 23
4 ;".7% x # : ;17.#7 x 1 4 ;37.=7
3. Calculate avera#e C/" ratio
4 ;37.=7-;#7.77 x 1776
4 %1.%6
72
". Calculate the brea%even point
4 fixed costs 8 C-* ratio
4 ;3%777 8 7.%1%
4 ;#=""3 2rounded3
#. Calculate revenue ratio of mi)
4 2# x ;<3 ? 21 x ;1#3
4 3# ? 1# or < ? 3
%. Calculate breakeven sales
+ 4 ;#=""2 x <-17 4 ;"7@7@ 2rounded3
D 4 ;#=""2 x 3-17 4 ;1<#33 2rounded3
3.2.# ()ercise -
Calculate the breakeven sales revenue of product 'eta )amma and &elta 2see
Exercise 2 above3 using the approach sho$n in Example 3.
"olution+
73
3.2.% Points to !ear in .in$
(ny change in the proportions of products in the mix $ill change the contribution per
mix and the average C-* ratio and hence the breakeven point.
2a3 Af the mi) shifts to0ar$s pro$ucts 0ith lo0er contribution mar#ins the
brea%even point (in units) 0ill increase and profits 0ill fall unless there is a
corresponding increase in total revenue.
2b3 ( shift to$ards products $ith hi#her contribution mar#ins $ithout a
corresponding decrease in revenues $ill cause an increase in profits and a
lo0er brea%even point.
2c3 Af sales are at the specified level but not in the specifie$ mi) there $ill be
either a profit or a loss depending on $hether the mi) shifts to0ar$s
pro$ucts 0ith hi#her or lo0er contribution mar#ins.
-.- .ar#in of safety for multiple pro$ucts
3.3.1 /he mar#in of safety for a multi!product organisation is e*ual to the bu$#ete$ sales
in the stan$ar$ mi) less the brea%even sales in the stan$ar$ mi). At may be
expressed as a percentage of the budgeted sales.
3.3.2 ()ample 1
'( produces and sells t$o products. /he G sells for ;= per unit and has a total
variable cost of ;3.=7 per unit $hile the . sells for ;1" per unit and has a total
variable cost of ;".27. 1or every five units of G sold six units of . are sold. '(Hs
fixed costs are ;"3=@7 per period.
'udgeted sales revenue for next period is ;<""77 in the standard mix.
e*uire$+
Calculate the margin of safety in terms of sales revenue and also as a percentage of
budgeted sales revenues.
74
"olution+
1. Calculate contribution per unit
G .
; per unit ; per unit
*elling price =.77 1".77
Variable cost 3.=7 ".27
Contribution ".27 @.=7
2. Calculate contribution per mix
4 ;".27 x # : ;@.=7 x % 4 ;<@.=7
3. Calculate the breakeven point in terms of the number of mixes
4 fixed costs - contribution per mix
4 ;"3=@7 - ;<@.=7
4 ##7 mixes
". Calculate the breakeven point in terms of the number of units of products
4 2##7 x #3 2<#7 units of G and 2##7 x %3 3377 units of .
#. Calculate the breakeven point in terms of revenue
4 22<#7 x ;=3 : 23377 x ;1"3
4 ;22777 of G and ;"%277 of .
4 ;%=277 in total
%. Calculate the margin of safety
4 budgeted sales 5 breakeven sales
4 ;<""77 5 ;%=277
4 ;%277 sales in total in the standard mix
4 ;%277 - ;<""77 x 1776
4 =.36 of budgeted sales
75
-.1 'ar#et profits for multiple pro$ucts
3.".1 /he number of mixes of products reIuired to be sold to achieve a target profit is
calculated as?
(fi)e$ costs 2 re*uire$ profit)/contribution per mi).
3.".2 ()ample 3
(n organisation makes and sells three products 1 ) and J. /he products are sold in
the proportions 1?)?J 4 2?1?3. /he organisationHs fixed costs are ;=7777 per month
and details of the products are as follo$s.
*elling price Variable cost
Product ; per unit ; per unit
1 22 1%
) 1# 1@
J 1@ 13
/he organisation $ishes to earn a profit of ;#2777 next month. Calculate the reIuired
sales value of each product in order to achieve this target profit.
"olution+
1. Calculate contribution per unit
1 ) J
; per unit ; per unit ; per unit
*elling price 22 1# 1@
Variable cost 1% 12 13
Contribution % 3 %
2. Calculate contribution per mix
4 2;% x 23 : 2;3 x 13 : 2;% x 33
4 ;33
3. Calculate the reIuired number of mixes
4 21ixed costs : reIuired profit3-contribution per mix
4 2;=7777 : ;#27773-;33
4 "777 mixes
76
". Calculate the reIuired sales in terms of the number of units of the products and
sales revenue of each product
Product Knits *elling price *ales revenue
reIuired
; per unit ;
1 "777 x 2 =777 22 1<%777
) "777 x 1 "777 1# %7777
J "777 x 3 12777 1@ 22=777
/otal "%"777
/he sales revenue of ;"%"777 $ill generate a profit of ;#2777 if the products are
sold in the mix 2?1?3.
(lternatively the C-* ratio could be used to determine the reIuired sales revenue for a
profit of ;#2777. /he method is again similar to that demonstrated earlier $hen
calculating the breakeven point.
3.".3 ()ample 4
Ksing the information as Example # calculate the reIuired sales of each products by
using the C-* ratio.
"olution+
1. Calculate revenue per mix
4 22 x ;223 : 21 x ;1#3 : 23 x ;1@3
4 ;11%
2. Calculate contribution per mix
4 2;% x 23 : 2;3 x 13 : 2;% x 33
4 ;33
3. Calculate average C-* ratio
4 2;33-;11%3 x 1776
4 2=."#6
". Calculate the reIuired total revenue
4 reIuired contribution 8 C-* ratio
4 2;=7777 : ;#27773 8 2=."#6
4 ;"%3@<2
#. Calculate revenue ratio of mix
77
4 22 x ;223 ? 21 x ;1#3 ? 23 x ;1@3
4 "" ? 1# ? #<
%. Calculate reIuired sales
.eIuired sales of 1 4 ""-11% x ;"%3@<2 4 ;1<#@=@
.eIuired sales of ) 4 1#-11% x ;"%3@<2 4 ;#@@@%
.eIuired sales of J 4 #<-11% x ;"%3@<2 4 ;22<@=%
Ghich allo$ing for roundings is the same ans$er as calculated in the first example.
-.3 .ulti5pro$uct brea%even charts
(A) !rea%even charts
3.#.1 'reakeven charts for multiple products can be dra$n if a constant pro$uct sales mi)
is assume$.
3.#.2 Jere there are three approaches to dra$ the multi!product breakeven charts.
3.#.3 ()ample 7 6 Approach 1+ Output in 7 "ales an$ a Constant Pro$uct .i)
(ssume that budgeted sales are 2777 units of L "777 units of F and 3777 units of
M. ( breakeven chart $ould make the assumption that output and sales of L F and M
are in the proportions 2777? "777? 3777 at all levels of activity in other $ords that
the sales mix is HfixedH in these proportions.
Ge begin by carrying out some calculations.
'udgeted costs Costs .evenue
; ;
Variable costs of L 22777 x ;33 %777 L 22777 x ;=3 1%777
Variable costs of F 2"777 x ;"3 1%777 F 2"777 x ;%3 2"777
Variable costs of M 23777 x ;#3 1#777 M 23777 x ;%3 1=777
/otal variable costs 3<777 'udgeted
revenue
#=777
1ixed costs 17777
/otal budgeted costs "<777
/he breakeven chart can no$ be dra$n.
78
/he breakeven point is approximately ;2<#77 of sales revenue. /his may either be
read from the chart or computed mathematically.
2a3 /he budgeted C-* ratio for all three products together is contribution-sales 4
;2#=777 5 3<7773-;#=777 4 3%.216.
2b3 /he reIuired contribution to break even is ;17777 the amount of fixed costs.
/he breakeven point is ;17777-3%.216 4 ;2<#77 2approx3 in sales revenue.
/he margin of safety is approximately ;2#=777 5 2<#773 4 ;37#77.
3.#." ()ample 8 6 Approach 2+ Pro$ucts in "e*uence
/he products could be plotted in a particular seIuence 2say L first then F then M3.
Ksing the data from (pproach 1 $e can calculate cumulative costs and revenues as
follo$s.
Product Cumulative units Cumulative costs Cumulative revenue
; ;
Dil 17777 Dil
L 22777 units3 2777 1%777 1%777
F 2"777 units3 %777 32777 "7777
M 23777 units3 @777 "<777 #=777
/he breakeven chart can no$ be dra$n.
79
An this case the breakeven point occurs at 2777 units of sales 22777 units of product
L3. /he margin of safety is roughly "777 units of F and 3777 units of M.
3.#.# ()ample 9 6 Approach -+ Output in 'erms of : of ;orecast "ales an$ a
Constant Pro$uct .i)
/he breakeven point can be read from the graph as approximately "=6 of forecast
sales 2;37777 of revenue3.
(lternatively $ith contribution of ;2#=777 5 3<7773 4 ;21777 one percent of
forecast sales is associated $ith ;21777-177 4 ;217 contribution.
'reakeven point 263 4 fixed costs-contribution per 16
4 ;17777-;217 4 "<.%26
+argin of safety 4 2177 5 "<.%23 4 #2.3=6
80
(!) .ulti5pro$uct P/V charts
3.#.% /he same information could be sho$n on a P-V chart.
3.#.< ()ample 1<
*ame information as Example <
Product Contribution *ales C-* ratio
; ; 6
L 17777 1%777 %2.#7
F =777 2"777 33.33
M 3777 1=777 1%.%<
/otal 21777 #=777 3%.21
'y convention the pro$ucts are sho0n in$ivi$ually on a P-V chart from left to
ri#ht in or$er of the si=e of their C/" ratio. An this example product L $ill be
plotted first then product F and finally product M. ( dotted line is used to sho$ the
cumulative profit/loss an$ the cumulative sales as each productHs sales and
contribution in turn are added to the sales mix.
Product Cumulative sales Cumulative profit
; ;
L 1%777 2;1%777 5 ;1%7773 !
L and F "7777 =777
81
L F and M #=777 11777
Fou $ill see on the graph $hich follo$s that these three pairs of data are used to plot
the dotted line to indicate the contribution from each product. /he solid line $hich
,oins the t$o ends of this dotted line indicates the average profit $hich $ill be earned
from sales of the three products in this mix.
/he diagram hi#hli#hts the follo$ing points.
2a3 *ince L is the most profitable in terms of C-* ratio it might be $orth
considering an increase in the sales of L even if there is a conseIuent fall in
the sales of M.
2b3 (lternatively the pricing structure of the products should be revie$ed and a
decision made as to $hether the price of product M should be raised so as to
increase its C-* ratio 2although an increase is likely to result in some fall in
sales volume3.
/he multi5pro$uct P/V chart therefore helps to i$entify the follo$ing.
2a3 /he overall company breakeven point.
2b3 Ghich products should be expanded in output and $hich if any should be
discontinued.
2c3 Ghat effect changes in selling price and sales volume $ill have on the
82
companyHs breakeven point and profit.
3.#.= ()ercise 1
( company sells three products L F and M. Cost and sales data for one period are as
follo$s.
L F M
*ales volume 2777 units 2777 units #777 units
*ales price per unit ;3 ;" ;2
Variable cost per unit ;2.2# ;3.#7 ;1.2#
/otal fixed costs ;32#7
e*uire$+
Construct a multi!product P-V chart based on the above information on the axes
belo$.
83
1. ;urther Aspects of CVP Analysis
".1 /he usefulness of CVP analysis is restricted by its unrealistic assumptions such as
constant sales price at all levels of activity. Jo$ever CVP has the advantage of being
more easily un$erstoo$ by non5financial mana#ers due to its graphical depiction of
cost and revenue data.
".2 >imitations+
2a3 At is assumed that fi)e$ costs are the same in total an$ variable costs are the
same per unit at all levels of output. /his assumption is a great simplification.
2i3 1ixed costs $ill change if output falls or increases substantially 2most
fixed costs are step costs3.
2ii3 /he variable cost per unit $ill decrease $here economies of scale are
made at higher output volumes but the variable cost per unit $ill also
eventually rise $hen diseconomies of scale begin to appear at even
higher volumes of output 2for example the extra cost of labour in
overtime $orking3.
2b3 /he assumption is only correct $ithin a normal range or relevant range of
output. At is generally assumed that both the budgeted output and the breakeven
point lie 0ithin this relevant ran#e.
2c3 At is assumed that sales prices 0ill be constant at all levels of activity. /his
may not be true especially at higher volumes of output $here the price may
have to be reduced to $in the extra sales.
2d3 Pro$uction an$ sales are assume$ to be the same so that the conseIuences
of any increase in inventory levels or of Hde!stockingH are ignored.
2e3 ?ncertainty in the estimates of fixed costs and unit variable costs is often
i#nore$.
".3 A$vanta#es+
2a3 ,raphical representation of cost and revenue data 2breakeven charts3 can be
more easily un$erstoo$ by non!financial managers.
2b3 ( breakeven model enables profit or loss at any level of activity $ithin the
range for $hich the model is valid to be $etermine$ and the C/" ratio can
in$icate the relative profitability of $ifferent pro$ucts.
2c3 Jighlighting the breakeven point and the margin of safety gives managers
some in$ication of the level of ris% involve$.
84
()amination "tyle @uestions
@uestion 1 6 !rea%even Chart 0ith Ancreases in ;i)e$ Costs
2a3 Adentify and discuss briefly five assumptions underlying cost!volume!profit analysis.
217 marks3
2b3 ( local authority $hose area include a holiday resort situated on the east coast
operates for 37 $eeks each year a holiday home $hich is let to visiting parties of
children in care from other authorities. /he children are accompanied by their o$n
house mothers $ho supervise them throughout their holiday. 1rom six to fifteen guests
are accepted on terms of N177 per person per $eek. Do differential charges exist for
adults and children.
Geekly costs incurred by the host authority are?
N per guest
1ood 2#
Electricity for heating and cooking 3
&omestic 2laundry cleaning etc.3 expenses #
Kse of minibus 17
*easonal staff supervise and carry out the necessary duties at the home at a cost of
N11777 for the 37!$eek period. /his provides staffing sufficient for six to ten guests
per $eek but if eleven or more guests are to be accommodated additional staff at a total
cost of N277 per $eek are engaged for the $hole of the 37!$eek period.
.ent including rates for the property is N"777 per annum and the garden of the home
is maintained by the councilEs recreation department $hich charges a nominal fee of
N1777 per annum.
e*uire$+
2i3 /abulate the appropriate figures in such a $ay as to sho$ the break!even point2s3
and to comment on your figures. 2= marks3
2ii3 &ra$ on the graph paper provided a chart to illustrate your ans$er to 2b32i3
above. 2< marks3
2/otal 2# marks3
85
@uestion 2 6 .ulti5pro$uct Profit5volume ,raph
OP 0imited has prepared a budget for the next 12 months $hen it intends to make and sell
four products details of $hich are sho$n belo$?
Pro$uct "ales in units "ellin# price per unit Variable cost per unit
(<<<) B B
O 17 27 1".77
P 17 "7 =.77
0 #7 " ".27
+ 27 17 <.77
'udgeted fixed costs are N2"7777 per annum and total assets employed are N#<7777.
e*uire$+
2a3 Calculate the total contribution earned by each product and their combined total
contributions. 22 marks3
2b3 Plot the data of your ans$er to 2a3 above in the form of a contribution to sales graph 2or
P-V graph3 on the graph paper provided. 2% marks3
2c3 Explain your graph to management to comment on the results sho$n and to state the
break!even point. 2" marks3
2d3 &escribe briefly three $ays in $hich the overall contribution to sales ratio could be
improved. 23 marks3
2/otal 1# marks3
86
@uestion -
Fou are the assistant management accountant of QLF plc a food manufacturer. /he 'oard of
&irectors is concerned that its operational managers may not be fully a$are of the importance
of understanding the costs incurred by the business and the effect that this has on their
operational decision making. An addition the operational managers need to be a$are of the
implications of their pricing policy $hen trying to increase the volume of sales.
Fou are scheduled to make a presentation to the operational managers tomorro$ to explain to
them the different costs that are incurred by the business the results of some research that has
been conducted into the implications for pricing and the importance of understanding these
issues for their decision making. /he diagram on the next page has already been prepared for
the presentation.
e*uire$+
Fou are reIuired to interpret the diagram and explain ho$ it illustrates issues that the
operational managers should consider $hen making decisions. 2Dote? your ans$er must
include explanations of the *ales .evenue /otal Cost and 1ixed Cost lines and the
significance of each of the activity levels labelled ( ' C &.3 217 marks3
87
88
@uestion 1
.&1 0td offers four services to television companies /he number of services provided is
measured in service units and details of .&1 0tdHs draft budget for its year ending 37 Oune
277# are as follo$s.
*ervice P *ervice 0 *ervice + *ervice D
Do. of service units 1777 2377 1"#7 1@<7
*elling price per unit 2;3 1= 1% 12 27
Variable cost per unit 2;3 = 17 13 13
1ixed cost per unit 2;3 2 3 2 "
/he budgeted level of activity sho$n in the table above has been based on fully meeting the
forecasted market demand for each type of service.
/he follo$ing chart has been prepared based on the draft budget above.
e*uire$+
2a3 Explain the meaning of the values sho$n as points ( and ' on the chart. 2Dote.
Calculations are not reIuired.3 2" marks3
2b3 1urther investigation into the nature of the fixed costs has sho$n that some of those
89
sho$n in the original budget are incurred as a direct result of providing specific services
as follo$s.
;
*ervice P ""77
*ervice 0 3<77
*ervice + Dil
*ervice D 2%#7
/he remaining budgeted fixed costs are general fixed costs that $ill be incurred
regardless of the type and number of services provided.
.&1 0td entered into a three!year contract in Oune 2772 $hich reIuires it to provide
#77 units of service + per year or suffer significant financial penalties. /hese services
are included in the budgeted demand.
e*uire$+
2i3 Evaluate the financial viability of each of the four services currently provided.
2% marks3
2ii3 .ecommend the operating plan that $ill maximise profit for the year ended 37
Oune 277# and state the resulting profit. Explain the assumptions that led to your
decision and other factors that should be considered. 2# marks3
2iii3 Calculate the overall breakeven sales value for the operating plan you have
recommended in ans$er to 2b32ii3 stating clearly the assumptions made in your
calculations. 2# marks3
2iv3 Comment on any limitations of using breakeven analysis for decision making
purposes. 2# marks3
2/otal 4 2# marks3
90