Cost-volume-profit

(CVP) analysis
Dr. Sujeewa Damayanthi
Department of Accounting
Faculty of Management & Finance
University of Colombo
Learning outcomes
• Distinguish between fixed cost and variable cost and use this
distinction to explain the relationship between cost, volume
and profit.
• Calculate break-even, contribution margin ratio/profit-volume
ratio for some activity.
• Apply CVP analysis in a multi-product setting.

• Explain the operating leverage and its application.

• Discuss the weaknesses of break-even analysis.

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 From previous
knowledge
• Cost represents the resources that have to be sacrificed to
achieve a business objective.
• The objective may be to make a particular product, to provide
a particular service, to operate an IT department and so on.
• The costs incurred by a business may be classified in various
ways and one important way is according to how they behave
in relation to changes in the volume of activity (behavior of
cost).
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 From previous
knowledge
• Do you remember fixed costs
Cost
and variable costs?
VC
• Fixed cost - costs that do not
change with output or level or
FC
activity, in the short run.
• Variable cost - any costs that
change when output level is Output

changed are considered to be

variable costs. 4
Total cost against
volume of activity
Cost

Total costs

Variable costs

Fixed costs

Unit of Output

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Break-even, what is it?
Break-even analysis simply looks at the relationship
between:
Profit Cost

Volume

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Break-even point
• The break-even point is the point at which the
business has sold enough units (this could be goods
manufactured or a service) to cover its total costs.
• At this point there is neither profit nor loss: that is,
the activity breaks even.
• Fixed costs in break-even analysis are classed as
period costs.
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Break-even chart
Cost
Total sales
revenue
Profit
Break-even point

Total costs
Variable costs
Loss

Fixed costs

Unit of Output

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 How to calculate break-
even point?
• Break-even point in units:

• Total fixed cost = break-even in units*contribution per unit

• Break-even point in sales value:

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 What is contribution
margin ratio?
• Contribution margin ratio is the contribution from an
activity expressed as a percentage of the sales revenue.

• The ratio provides an impression of the extent to which

sales revenue is eaten away by variable cost.

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Example
Cottage Industries Ltd makes baskets. The fixed costs of
operating the workshop for a month total Rs 125,000.
Each basket requires materials that cost Rs 500. Each
basket takes one hour to make, and the business pays
the basket makers Rs 2,500 an hour. The basket makers
are all on contracts such that if they do not work for
any reason, they are not paid. The baskets are sold to a
wholesaler for Rs 3,500 each.
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Example Cont.
Cottage Industries Ltd expects to sell 500 baskets a
month. The business has the opportunity to rent a
basket-making machine. Doing so would increase the
total fixed cost of operating the workshop for a month
to Rs 750,000. Using the machine would reduce the
labour time to half an hour per basket. The basket
makers would still be paid Rs 2,500 an hour.
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 Example Cont.
1. How much profit would the business make each month
from selling baskets assuming that the basket-making
machine is not rented; and assuming that it is rented?

2. What is the BEP, if the machine is rented and not

rented?

3. What do you notice about the figures that you

calculate?
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 Solution
1. Estimated monthly profit from basket making:
Without the machine With the machine
Rs Rs Rs Rs
Sales Revenue (500*Rs 3,500) 1,750,000 1,750,000
Material (500*Rs 500) (250,000) (250,000)
Labour (500*1 hr*Rs 2,500) (1,250,000) -
(500*1/2hr*Rs 2,500) - (625,000)
Fixed cost (125,000) (1,625,000 (750,000) (1,625,000
) )
Profit 125,000 125,000

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 Solution Cont.
2. BEP in number of baskets:
Without the machine With the machine
Break-even point
250 baskets 429 baskets

3. What do you notice about the figures that you

calculate?

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Using the break-even
formula, one step
further
• Break-even formula can be extended to help
calculate how many units need to be sold in
order to achieve a certain profit.
• Achieving a target profit:

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 Example
What volume of activity is required by Cottage Industries
Ltd in order to make a profit of Rs 1,000,000 a month?
(assuming that the basket-making machine is not rented
and assuming that it is rented)
Without the machine With the machine
Volume of activity
2,250 baskets 1,000 baskets

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 Margin of safety
• Margin of safety is a safety net.
• Margin of safety is the extent to which the planned volume of
output or sales lies above the break-even point. How much
can sales drop before a loss-making situation is materializing
Margin of safety = Normal demand – break-even units
• Using the MOS, the current profit can be calculated
Profit = Margin of safety * Contribution per unit
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 Example
Calculate Margin of Safety for Cottage Industries Ltd
without the machine and with the new machine.
Without the With the machine
machine (number of
(number of baskets) baskets)
Expected volume of sales 500 500
Break even point (250) (429)
Margin of safety 250 units 71 units

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Calculate break-even
with multiple products
123 -BEP
Step 1 – Identify the sales mix

Step 2 – Calculate the weighted average

contribution margin

Step 3 – Use the break-even formula

Step 4 – Calculate the break-even units from each

product using the sales mix

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Example
Alpha Ltd makes three different products, the details of
which are as follows:
Basic Premium Superend
Units sold 420 units 175 units 105 units
Selling price per unit Rs 600 Rs 850 Rs 1325
Variable cost per unit Rs 425 Rs 650 Rs 825

Company has a fixed cost of Rs 138,000. How many

units of each model must the company produce in order
to break-even?
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Solution
Identify sales mix of the company:

Basic Premium Supervend

Units sold 420 units 175 units 105 units
Sales mix
60% 25% 15%

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 Solution Cont.
Weighted average contribution margin:
Basic Premium Supervend
Selling price per unit Rs 600 Rs 850 Rs 1325
Variable cost per unit Rs 425 Rs 650 Rs 825
Contribution per unit Rs 175 Rs 200 Rs 500
Weighted average 175*60% 200*25% 500*15%
contribution margin 105 50 75 230

Use the Break even formula: 138,000/230 = 600 units

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 Solution Cont.
Calculate the break-even units from each product
using the sales mix :
Basic Premium Supervend
Break-even units 600*60% 600*25% 600*15%
from each product 360 units 150 units 90 units

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 Operating leverage
• The cost structure of the company can have a
significant impact on profit of a company.
• High fixed and lower variable cost structure will results
in greater increase in profits as sales increase and
greater reduction in profits as sales decrease.
• Operating leverage measures the sensitivity of profits
to changes in sales.
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 Operating leverage
• The degree of operating leverage can be measured for
a given level of sales using following formula:

• In the example of Cottage industries Ltd calculate the

degree of operating leverage for both situations (with
the machine and without the machine).

ACT 1201 MANAGEMENT ACCOUNTING 26

 Example
Degree of operating leverage at Cottage Industries Ltd:
Without the With the machine
machine
Degree of
operating leverage
2 times 7 times

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Operating leverage
• In the example of Cottage Industries Ltd, degree of
operating leverage is high when using the machine
than it has if not using it.
• Increasing the level of operating leverage makes
profits more sensitive to changes in the volume of
activity.

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Example
Sensitivity of profits to changes in volume at
Cottage Industries Ltd as follows:
Without the machine
Volume (number of 500 1000 1500
baskets)
Rs Rs Rs
Contribution 250,000 500,000 750,000
Fixed cost 125,000 125,000 125,000
Profit 125,000 375,000 625,000
Operating leverage 2 times 1.33 times 1.2 times

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Example Cont.
Sensitivity of profits to changes in volume at
Cottage Industries Ltd as follows:
With the machine
Volume (number of 500 1000 1500
baskets)
Rs Rs Rs
Contribution 875,000 1,750,000 2,625,000
Fixed cost 750,000 750,000 750,000
Profit 125,000 1,000,000 1,875,000
Operating leverage 7 times 1.75 times 1.4 times

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 Limitations/assumptions
of break-even analysis
• It assumes all other variables remain constant.

• Single product or constant sales mix.

• Total costs and total revenue are linear functions of output.

• Profits are calculated on a variable costing basis.

• Costs can be accurately analyzed into fixed and variable

elements.
• Analysis applies only to the relevant range.

• Analysis applies only to a short-term time horizon. 31

Using contribution to
make decisions
• In marginal analysis is concerned with the costs and revenues that
vary with the decision and so this usually means that fixed cost is
ignored.

• Marginal analysis may be used in four key areas of decision making:

- Accepting/rejecting special contracts;

- Determining the most efficient use of scarce resources;

- Make-or-buy decisions;

- Closing or continuation decisions

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