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01 technical

cost-volume-
profit relevant to acca qualification paper F5

In any business, or, indeed, in life CVP analysis looks primarily at the effects of
in general, hindsight is a beautiful
thing. If only we could look into a differing levels of activity on the financial
crystal ball and find out exactly how results of a business. The reason for the
many customers were going to buy
our product, we would be able to particular focus on sales volume is because,
make perfect business decisions and in the short-run, sales price, and the cost of
maximise profits.
Take a restaurant, for example. If materials and labour, are usually known with
the owners knew exactly how many a degree of accuracy.
customers would come in each evening
and the number and type of meals that
they would order, they could ensure that This type of analysis is known as It can, therefore, say with some
staffing levels were exactly accurate and ‘cost-volume-profit analysis’ (CVP degree of certainty that the
no waste occurred in the kitchen. The analysis) and the purpose of this article contribution per unit (sales price less
reality is, of course, that decisions such is to cover some of the straight forward variable costs) is $20. Company A may
as staffing and food purchases have calculations and graphs required for also have fixed costs of $200,000 per
to be made on the basis of estimates, this part of the Paper F5 syllabus, while annum, which again, are fairly easy
with these estimates being based on also considering the assumptions which to predict. However, when we ask the
past experience. underlie any such analysis. question: ‘Will the company make a
While management accounting profit in that year?’, the answer is ‘We
information can’t really help much THE OBJECTIVE OF CVP ANALYSIS don’t know’. We don’t know because
with the crystal ball, it can be of use CVP analysis looks primarily at the we don’t know the sales volume for
in providing the answers to questions effects of differing levels of activity the year.
about the consequences of different on the financial results of a business. However, we can work out how many
courses of action. One of the most The reason for the particular focus sales the business needs to make in
important decisions that needs to be on sales volume is because, in the order to make a profit and this is where
made before any business even starts short-run, sales price, and the cost CVP analysis begins.
is ‘how much do we need to sell in of materials and labour, are usually
order to break‑even?’ By ‘break‑even’ known with a degree of accuracy. Methods for calculating the
we mean simply covering all our costs Sales volume, however, is not usually break‑even point
without making a profit. so predictable and therefore, in the The break-even point is when total
short-run, profitability often hinges revenues and total costs are equal,
upon it. For example, Company A may that is, there is no profit but also no
know that the sales price for product loss made. There are three methods for
x in a particular year is going to be ascertaining this break-even point:
in the region of $50 and its variable
costs are approximately $30.
student accountant issue 14/2010
02
Studying Paper F5?
Performance objectives 12, 13 and 14 are relevant to this exam

analysis
1 The equation method It would, therefore, be 2 The contribution margin method
A little bit of simple maths can inappropriate to use a unit fixed This second approach uses a
help us answer numerous different cost since this would vary depending little bit of algebra to rewrite our
cost‑volume-profit questions. on output. Sales price and variable equation above, concentrating
We know that total revenues are costs, on the other hand, are on the use of the ‘contribution
found by multiplying unit selling price assumed to remain constant for all margin’. The contribution margin
(USP) by quantity sold (Q). Also, levels of output in the short-run, and, is equal to total revenue less total
total costs are made up firstly of therefore, unit costs are appropriate. variable costs. Alternatively, the
total fixed costs (FC) and secondly Continuing with our equation, we unit contribution margin (UCM)
by variable costs (VC). Total variable now set P to zero in order to find out is the unit selling price (USP) less
costs are found by multiplying unit how many items we need to sell the unit variable cost (UVC). Hence,
variable cost (UVC) by total quantity in order to make no profit, ie to the formula from our mathematical
(Q). Any excess of total revenue over break even: method above is manipulated in
total costs will give rise to profit the following way:
(P). By putting this information (50Q) – (30Q) – 200,000 = 0
into a simple equation, we come up 20Q – 200,000 = 0 (USP x Q) – (UVC x Q) – FC = P
with a method of answering CVP 20Q = 200,000 (USP – UVC) x Q = FC + P
type questions. This is done below Q = 10,000 units. UCM x Q = FC + P
continuing with the example of Q = FC + P
Company A above. The equation has given us our UCM
answer. If Company A sells less than
Total revenue – total variable costs – 10,000 units, it will make a loss; if So, if P=0 (because we want to find
total fixed costs = Profit it sells exactly 10,000 units, it will the break-even point), then we would
(USP x Q) – (UVC x Q) – FC = P break-even, and if it sells more than simply take our fixed costs and
(50Q) – (30Q) – 200,000 = P 10,000 units, it will make a profit. divide them by our unit contribution
margin. We often see the unit
Note: total fixed costs are used rather contribution margin referred to as the
than unit fixed costs since unit fixed ‘contribution per unit’.
costs will vary depending on the level Applying this approach to
of output. Company A again:

UCM = 20, FC = 200,000 and P = 0.


Q = FC
The contribution margin method uses a UCM
little bit of algebra to rewrite our equation Q = 200,000
20
above, concentrating on the use of the
‘contribution margin’. Therefore Q = 10,000 units
03 technical

3 The graphical method FIGURE 1: COMPANY A: Break-even CHART


With the graphical method, the total
costs and total revenue lines are $
plotted on a graph; $ is shown on
the y axis and units are shown on 1,200,000
the x axis. The point where the total
cost and revenue lines intersect is
the break-even point. The amount
of profit or loss at different output 1,000,000 Total revenue
levels is represented by the distance
between the total cost and total
revenue lines. Figure 1 opposite
shows a typical break-even chart for 800,000
Company A. The gap between the Total costs
fixed costs and the total costs line
represents variable costs.
Alternatively, a contribution graph 600,000 Break-even point
could be drawn. While this is not
specifically covered by the Paper F5
syllabus, it is still useful to see it.
This is very similar to a break-even 400,000
chart, the only difference being that
instead of showing a fixed cost line,
a variable cost line is shown instead. Fixed costs
Hence, it is the difference between 200,000
the variable cost line and the total
cost line that represents fixed costs.
The advantage of this is that it
emphasises contribution as it is 0
represented by the gap between the 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000
total revenue and the variable cost
lines. This is shown for Company A in Units sold
Figure 2 opposite.
Finally, a profit–volume graph
could be drawn, which emphasises
the impact of volume changes on
profit (Figure 3 on page 7). This
is key to the Paper F5 syllabus and
is discussed in more detail later in
this article.
student accountant issue 14/2010
04

FIGURE 2: COMPANY A: contribution graph Ascertaining the sales


volume required to achieve a
$ target profit
As well as ascertaining the break-even
1,200,000 point, there are other routine calculations
that it is just as important to understand.
For example, a business may want to
know how many items it must sell in
1,000,000 Total revenue order to attain a target profit.

Example 1

Contribution
Company A wants to achieve a target
800,000 Total costs profit of $300,000. The sales volume
necessary in order to achieve this
profit can be ascertained using any of
Break-even point the three methods outlined above. If
600,000 Variable costs the equation method is used, the profit
of $300,000 is put into the equation
rather than the profit of $0:

400,000 (50Q) – (30Q) – 200,000 = 300,000


20Q – 200,000 = 300,000
20Q = 500,000
Q = 25,000 units.
200,000
Alternatively, the contribution method
can be used:

0 UCM = 20, FC = 200,000 and P =


0 5,000 10,000 15,000 20,000 25,000 300,000.
Q = FC + P
Units sold UCM
Q = 200,000 + 300,000
20

A contribution graph shows the difference Therefore Q = 25,000 units.


between the variable cost line and the total Finally, the answer can be read from the
cost line that represents fixed costs. graph, although this method becomes
clumsier than the previous two. The profit
An advantage of this is that it emphasises will be $300,000 where the gap between
contribution as it is represented by the gap the total revenue and total cost line is
$300,000, since the gap represents
between the total revenue and variable profit (after the break-even point) or loss
cost lines. (before the break-even point.)
05 technical

This is not a quick enough For Company A: $20/$50 = 0.4 The C/S ratio is useful in its own right
method to use in an exam so it is as it tells us what percentage each $ of
not recommended. In multi-product situations, a weighted sales revenue contributes towards fixed
average C/S ratio is calculated by using costs; it is also invaluable in helping
Margin of safety the formula: us to quickly calculate the break-even
The margin of safety indicates by how point in $ sales revenue, or the sales
much sales can decrease before a loss Total contribution/total sales revenue revenue required to generate a target
occurs, ie it is the excess of budgeted profit. The break-even point can now be
revenues over break-even revenues. This weighted average C/S ratio can calculated this way for Company A:
Using Company A as an example, let’s then be used to find CVP information
assume that budgeted sales are 20,000 such as break-even point, margin of Fixed costs / contribution to sales ratio
units. The margin of safety can be safety etc. = $200,000/0.34375 = $581,819 of
found, in units, as follows: sales revenue.
Example 2
Budgeted sales – break-even sales = As well as producing product x To achieve a target profit of $300,000:
20,000 – 10,000 = 10,000 units. described above, Company A also
begins producing product y. The Fixed costs + required profit /
Alternatively, as is often the case, it following information is available for contribution to sales ratio = $200,000
may be calculated as a percentage: both products: + $300,000/0.34375 = $1,454,546.

Budgeted sales – break-even sales/ Product x Product y Of course, such calculations provide
budgeted sales. only estimated information because
In Company A’s case, it will be Sales price $50 $60 they assume that products x and y are
10,000/20,000 x 100 = 50%. Variable cost $30 $45 sold in a constant mix of 2x to 1y. In
Contribution per unit $20 $15 reality, this constant mix is unlikely
Finally, it could be calculated in terms Budgeted sales to exist and, at times, more y may be
of $ sales revenue as follows: (units) 20,000 10,000 sold than x. Such changes in the mix
Budgeted sales – break-even sales throughout a period, even if the overall
x selling price = 10,000 x $50 = The weighted average C/S ratio can be mix for the period is 2:1, will lead to the
$500,000. once again calculated by dividing the actual break-even point being different
total expected contribution by the total than anticipated. This point is touched
Contribution to sales ratio expected sales: upon again later in this article.
It is often useful in single product (20,000 x $20) + (10,000 x $15) /
situations, and essential in (20,000 x $50) + (10,000 x $60) =
multi‑product situations, to ascertain 34.375%
how much each $ sold actually
contributes towards the fixed costs. This
calculation is known as the contribution
to sales or C/S ratio. It is found in contribution to sales ratio is often useful
single product situations by either
simply dividing the total contribution by
in single product situations, and essential
the total sales revenue, or by dividing in multi‑product situations, to ascertain
the unit contribution margin (otherwise
known as contribution per unit) by the
how much each $ sold actually contributes
selling price: towards the fixed costs.
student accountant issue 14/2010
06

Multi-product
profit–volume charts Table 3: figure 3 continued
When discussing graphical methods
for establishing the break-even point, Product x Product y
we considered break-even charts and Sales price $50 $60
contribution graphs. These could also Variable cost $30 $45
be drawn for a company selling multiple Contribution per unit $20 $15
products, such as Company A in our Budgeted sales (units) 20,000 10,000
example. The one type of graph that C/S ratios 0.4 0.25
hasn’t yet been discussed is a Weighted average C/S ratio 0.34375
profit–volume graph. This is slightly Product ranking 1 2
different from the others in that it (most profitable first)
focuses purely on showing a profit/
loss line and doesn’t separately
show the cost and revenue lines. In Product Contribution Cumulative Revenue Cumulative
a multi‑product environment, it is profit/loss revenue
common to actually show two lines on $’000 $’000 $’000 $’000
the graph: one straight line, where a (Fixed costs) 0 (200) 0 0
constant mix between the products is X 400 200 1,000,000 1,000,000
assumed; and one bow-shaped line, Y 150 350 650,000 1,650,000
where it is assumed that the company
sells its most profitable product first
and then its next most profitable
product, and so on. In order to draw the In order to draw a multi-product/volume
graph, it is therefore necessary to work
out the C/S ratio of each product being
graph it is necessary to work out the C/S ratio
sold before ranking the products in of each product being sold.
order of profitability. It is easy here for
Company A, since only two products are
being produced, and so it is useful to Limitations of ¤ All other variables, apart from
draw a quick table (prevents mistakes in cost-volume‑profit analysis volume, remain constant, ie volume
the exam hall) in order to ascertain each ¤ Cost-volume-profit analysis is is the only factor that causes
of the points that need to be plotted on invaluable in demonstrating the revenues and costs to change.
the graph in order to show the profit/ effect on an organisation that In reality, this assumption may
loss lines. See Table 3 on the right. changes in volume (in particular), not hold true as, for example,
The graph can then be drawn costs and selling prices, have on economies of scale may be achieved
(Figure 3 on page 7), showing profit. However, its use is limited as volumes increase. Similarly,
cumulative sales on the x axis and because it is based on the following if there is a change in sales mix,
cumulative profit/loss on the y axis. assumptions: Either a single product revenues will change. Furthermore,
It can be observed from the graph is being sold or, if there are multiple it is often found that if sales
that, when the company sells its most products, these are sold in a constant volumes are to increase, sales
profitable product first (x) it breaks even mix. We have considered this above price must fall. These are only a
earlier than when it sells products in a in Figure 3 and seen that if the few reasons why the assumption
constant mix. The break-even point is constant mix assumption changes, may not hold true; there are
the point where each line cuts the x axis. so does the break-even point. many others.
07 technical

¤ The total cost and total revenue FIGURE 3: COMPANY A: multi-product–volume chart
functions are linear. This is only
likely to hold true within a short-run, $
restricted level of activity.
¤ Costs can be divided into a 400,000
component that is fixed and a
component that is variable. In reality, Product y
some costs may be semi-fixed,
such as telephone charges, whereby
there may be a fixed monthly rental 300,000
charge and a variable charge for
calls made.
¤ Fixed costs remain constant over the
‘relevant range’ – levels of activity in
which the business has experience 200,000
and can therefore perform a degree

st
of accurate analysis. It will either
fir
have operated at those activity levels
le
tab

before or studied them carefully


so that it can, for example, make 100,000
ofi
pr

accurate predictions of fixed costs in Sales in constant mix


st

that range.
Mo

¤ Profits are calculated on a variable


cost basis or, if absorption costing is
used, it is assumed that production 0
volumes are equal to sales volumes.
0 200,000 600,000 1,000,000 1,400,000 1,800,000
Ann Irons is examiner for Paper F5 400,000 800,000 1,200,000 1,600,000
Product x
–100,000 Sales $000

–200,000

–300,000

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