Chapter 18

Cost volume profit analysis

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 Outline
CVP analysis and the break-even point
Graphing CVP relationships
Target net profit
CVP analysis for management decisions
CVP analysis with multiple products
Including income taxes in CVP analysis
Assumptions underlying CVP analysis
An activity-based approach to CVP analysis
Financial planning models
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 What is cost volume profit
(CVP) analysis?
Determines the effect of changes in an
organisations sales volume on its
costs, revenue and profit
Provides answers to a series of short-
term changes can determine the
impact on revenue and costs quickly
Can be used in both profit-seeking and
not-for-profit organisations

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 The break-even point
The volume of sales where the total
revenues and costs are equal, and
the operation breaks even
At this level of sales, there is no profit
or loss
The break-even point can be
calculated for an entire organisation
or for individual projects or activities

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 Break-even formulas
Fixed costs
Break-even point (in units) =
Unit contributi on margin

Fixed costs
Break-even point (in sales dollars) =
Unit contributi on margin ratio

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 Terminology

Contribution margin (or variable

costing) statement
Total contribution margin
Unit contribution margin
Contribution margin ratio
Contribution margin percentage

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 Graphing cost volume
profit relationships
Shows how costs, revenue and profits
change as sales volume changes
Five steps
Draw the axes of the graph
Draw the fixed cost line
Draw the total cost line
Draw the total revenue line
Break-even point where the total
revenue and total cost lines intersect
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Cost volume profit graph, Melbourne
Theatre Company production Calypso

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 Profit volume (PV) graph
Shows the total amount of profit or
loss at different sales volumes
The graph intercepts the vertical axis
at the amount equal to the fixed costs
The break-even point is the point at
which the total profit/loss line crosses
the horizontal axis

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 Profit volume graph, Melbourne
Theatre Company production Calypso

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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-10
 Target net profit
A desired profit level determined by
management
The break-even formula can be used
to determine the sales volume
needed to achieve a particular target
profit
Fixed costs + target net profit
Target sales volume (in units) =
Unit contributi on margin
Fixed costs + target net profit
Target sales volume (in dollars) =
Unit contributi on ratio

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 Using CVP analysis for
management decision making
Safety margin
Difference between the budgeted sales
revenue and break-even sales revenue
Changes in fixed costs
Percentage change in fixed costs will
lead to a similar increase in the break-
even point (in units or dollars)
Changes in the contribution margin
per unit
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Multiple changes in key variables
May involve, for example
Decreasing variable costs per unit
Increasing selling prices
Undertaking a new advertising campaign
Leasing a new office
An incremental approach to analysis
Focuses on the differences in the total
contribution margin, fixed costs and
profits under the two alternatives

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 CVP analysis with multiple
products
Sales mix
The relative proportions of each type of product
sold by the organisation
Weighted average unit contribution margin
The average of the products unit contribution
margins, weighted by the sales mix
Fixed costs
Break-even point =
Weighted average unit contribution margin

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 Profit volume graph with multiple
products, Melbourne Theatre
Company production Calypso

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Including income taxes in CVP
analysis
Sales volume required to earn net
profit after tax

Fixed costs + target net profit after tax

=
(1 t)
unit contribution margin

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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 18-16
 Assumptions underlying
CVP analysis
The behaviour of total revenue is linear
The behaviour of total costs is linear over a
relevant range
For both variable and fixed costs, sales
volume is the only cost driver
The sales mix remains constant over the
relevant range
In manufacturing firms, the levels of inventory
at the beginning and end of the period are the
same
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 CVP analysis and
longer-term decisions
CVP analysis is usually regarded as a
short-term or tactical decision tool
Classification of costs as variable or
fixed is usually based on cost
behaviour over the short term
The financial impact of long-term
decisions is best analysed using
capital budgeting techniques
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 Treating CVP analysis
with caution
CVP analysis is a simplified model
The usefulness of CVP analysis may
be greater in less complex, smaller
firms, or for stand-alone projects
For larger, more complex firms, CVP
analysis can also be valuable as a
decision tool for the planning stages
of new projects and ventures
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 An activity-based approach
to CVP analysis

ABC categorises activities at unit,

batch, product or facility level
Batch, product and facility activities are
non-volume related activity costs
Total batch, product and facility level costs
Break-even point =
Selling price per unit - costsper unit

(cont.)

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An activity-based approach to CVP
analysis (cont.)

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 Planned activities and costs,
AccuTime Pty Ltd

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 Limiting assumptions of
CVP analysis using
activity-based costs
Total batch level costs are dependent
on the batch size and the break-
even/target production level
Management may change the batch
size at certain production volume levels
More complex models are needed
where there are multiple products
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 Including customer-related
costs in CVP analysis
Profit = Sales revenue (unit level costs
+ batch level costs
+ product level costs
+ order level costs
+ customer level costs
+ marketing level costs
+ facility level costs)
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 Financial planning models
Sensitivity analysis and CVP analysis
Can be run using spreadsheet software
Goal seek approaches
The analyst specifies the outcome, and the
software specifies the necessary inputs
What-if analysis
The analyst specifies changes in
assumptions and data to examine the effect
of these changes on the outputs

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 Profit model for AccuTime Pty Ltd
under activity-based costing

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 Summary
CVP analysis is a decision tool
The break-even point is the sales level at
which sales cover costs there is zero profit
The break-even formula can be modified to
calculate target profit
CVP analysis has several assumptions which
limit its usefulness for decision making
Activity-based approaches and financial
planning modelling can provide more
sophisticated models

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