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CHAPTER 9

COST-VOLUME-PROFIT RELATIONSHIPS
LEARNING OBJECTIVES

After studying this chapter, students should be able to:

1. Importance of cost-volume-profit analysis


2. Break even point analysis
3. Managing leverage and cost structure
4. Weaknesses of cost-profit-volume analysis

INTRODUCTION

Cost-Volume-Profit analysis is a core topic in the management accounting. CVP analysis is


concerned with analyzing the relationship between changes in output and changes in total sales
revenue, expenses and net profit. Manager are constantly faced with decisions about selling
prices, sales volume, sales mix and costs (variable and fixed) in order to find the right
combination of these four factors that will produce satisfactory profits. Moreover, a graphical
approach provides a useful representation of how costs, revenues and profits will behave for the
many possible output levels.

The objective of CVP analysis is to establish what will happen to the financial results if a
specified level of activity fluctuates.

BREAK-EVEN POINT ANALYSIS

The study of CVP is often called break-even analysis. The break-even point is the point when
total revenue and total costs are equal. In other words, at this point there is no net income or loss.
Both the variable and fixed costs are covered by sales revenue at the break-even point. The break-
even point represents a target of minimum sales volume that the manager must achieve because it
does indicate the level of sales necessary to avoid a loss.

Below is a very simple example to show various analytical techniques used in CVP analysis.

BIB Bhd. owned by Adura plans to rent an MBSA store. She is analyzing an average selling price
of RM 50 and average cost price of RM 30 per unit of book item. She targeted to sell 2000 units
of book items at the following costs:

Monthly fixed expenses:

Rent RM10,000
Wages of helpers RM 8,000
Other fixed costs RM 2,000
Total RM 20,000

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There are THREE approaches to determine break-even point:
1. Contribution Margin Approach
2. Equation Approach
3. Graphical Method

1. Contribution Margin Approach

By using this approach, each book item sells for RM 50, but RM 30 of this is used to
cover variable costs. This leaves RM 20 (RM 50 – RM 30) per unit of book item to
contribute to covering the fixed costs of RM 20,000. When enough book items have been
sold in one month, RM 20 contributions per food item add up to RM 20,000 then, Puan
Adura will break even.

BEP (UNITS) = FIXED COSTS


CONTRIBUTION MARGIN PER UNIT

= RM 20,000
RM 20

= 1,000 units

Puan Adura must sell 1,000 units of book items per month in order to break even.

 Contribution to Sales Ratio (C/S Ratio)

The calculation of break-even also can be computed in sales dollar instead of units. The
contribution to sales ratio is expressed as a percentage. Interpretation of the higher ratio
means the contribution grows more quickly as sales level increase.

From the above illustration, C/S ratio can be used to calculate break-even point as
follows:

C/S RATIO = CONTRIBUTION X 100


SALES
= RM 20 X 100
RM 50
= 40%

BEP = TOTAL FIXED COSTS


C/S RATIO
= RM 20,000
40%
= RM 50,000

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2. Equation Approach

This approach is based on the profit equation. Profit can be calculated as follows:

SALES REVENUE - VARIABLE COSTS – FIXED COSTS = PROFIT

Alternatively, it can be restated as follows:

(UNIT SELLING PRICE X SALES VOLUME) – (UNIT VARIABLE COSTS X


SALES VOLUME IN UNITS) – FIXED COSTS

To find break-even for a month for Puan Adura, it is assumed that profit is zero.

RM 50X – RM 30X –RM 20,000 = O


RM 20X = RM 20,000
X = 1,000 UNITS

In arriving break-even point, both approaches of contribution-margin approach and


equation approach have two equivalent techniques.

To simplify the CVP relationship, see as follows:

COST-VOLUME-PROFIT RELATIONSHIP

Direct material xxx


Direct labour xxx
Direct expenses xxx

Total variable cost xxx


Fixed cost xxx

Total cost xxx


Profit/loss xxx

Selling Price xxx

Alternatively, profit figure can be computed as follows which is known as Marginal Cost
Statement

(a) Contribution is the amount remaining from sales revenue after variable expenses have
been deducted.

Marginal Cost Statement

Sales XXX
Less: Variable Cost XXX

(a) Contribution XXX


Less : Fixed Cost XXX

Profit/Loss 3 XXX
Formula in CVP Analysis:

a. Contribution Margin Ratio (C/M Ratio)


or
Profit/Volume RATIO (P/V RATIO)

P/V ratio = Contribution X 100


Sales

P/V ratio is the ratio of contribution to sales

(OR)

b. P/V Ratio = Sales – Variable Cost X 100


Sales

P/V Ratio = Contribution Per Unit X 100


Selling Price Per Unit

(OR)

c. P/V Ratio = Change in Profit X 100


Change in Sales

d. Variable Cost = SALES (1 - P/V RATIO)

3. The Break-even Graph

There are basically three types of graphs that can be used, namely :

a) Traditional break – even graph / Cost – Volume – Profit graph


b) Contribution break-even graph
c) Profit – Volume graph

For illustration, look at the following table:

Total
Fixed
Sales Sales Total V.C Total Costs Profit /
Costs
(Loss)
(Units) (RM) (RM) (RM) (RM) (RM)
500 2500 1500 2000 3500 (1000)
1000 5000 3000 2000 5000 0
1500 7500 4500 2000 6500 1000
2000 10000 6000 2000 8000 2000

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a) Traditional break – even graph

b) Contribution break-even graph

c) Profit – Volume graph

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ASSUMPTIONS/LIMITATIONS OF CVP ANALYSIS

CVP analysis is a subject to a number of underlying assumptions and limitations:

1. The unit sales prices remain constant throughout the period being considered.
2. All costs can be easily identified as being either variable or fixed with a reasonable amount of
accuracy.
3. Variable costs will change in total amount proportionately with volume.
4. Total fixed costs will remain constant over the entire range of activity being considered.
5. Single or constant sales mix
6. Total costs and total revenue are linear functions of output. Total cost and total revenue
change proportionately to changes in volume.
7. Risk and uncertainty are ignored and perfect knowledge of cost and revenue functions is
assumed.
8. It is assumed that the firm is a price taker, i.e. a perfect market is deemed to exist.
9. The efficiency and productivity of the production and workers remain constant.

CONCLUSIONS

ASSUMPTIONS IN BREAK-EVEN ANALYSIS

a. Fixed Costs Is Constant In Total


b. Variable Costs Is Constant Per Unit
c. Selling Price Is Constant Per Unit
d. All Costs Can Be Resolved Into Fixed And Variable Costs
e. Efficiency and productivity are to be unchanged

LIMITATIONS OF BREAK-EVEN ANALYSIS

a. A fixed cost is fixed only within a given time span and over a given range of activity.
However, it may change from budget year to budget year when the activity level changes too
greatly.
b. Variable costs per unit is assumed to be constant. However, variable costs may fall as
volume increases and trade discounts or economies of large scale are achieved, and will then
rise when the demand for resources exceed supply.
c. Selling price may be reduced to achieve greater volume of sales.
d. In practice it is not always feasible to resolve all costs into their fixed and variable
elements.
e. Efficiency and productivity to change, thus affecting costs.
f. Volume, though important, it not the only factor affecting costs. Factors such as
efficiency, productivity, war, government legislation also affects costs.

The above assumptions act as major limitations of the CVP analysis, but nevertheless it is a
powerful tool for decision making in the short run.

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Self Review Questions

1. How CVP analysis can be used?

2. What are the basic assumptions underlying CVP analysis?

3. State 3 (THREE) approaches of determining break even point.

4. What information other than break-even point can be obtained by managers from a
CVP graph?

5. Define the following terms:

i) Break even point


ii) Break even analysis
iii) Margin of safety

6. Why margin of safety is an important part of CVP analysis for managers?