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Chapter 22

Cost-Volume-Profit Analysis
Cost-Volume-Profit
Analysis
 CVP analysis is a technique for studying the relationship between
cost, volume and profits. Examines the behavior of total
revenues, total costs, and operating income as changes occur in
the output level, selling price, variable costs or fixed cost
 It can be used to answer the questions like:
a. How much sales should be made to avoid the losses?
b. How much should be the sales to earn a desired profit?
c. What will be the effect of change in prices, costs and volume on
profits
d. Which product or product mix is most profitable?
e. Should we manufacture or buy some product or component?

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Assumptions of CVP
Analysis
 Expenses can be classified as either variable or fixed.
 CVP relationships are linear over a wide range of production and
sales.
 Sales prices, unit variable cost, and total fixed expenses will not vary
within the relevant range.
 Volume is the only cost driver.
 The relevant range of volume is specified.
 Inventory levels will be unchanged.
 The sales mix remains unchanged during the period.
 revenues change in relation to production and sales
 costs and prices are known
 if more than one product exists, the sales mix is constant
 we can ignore the time value of money
Objectives
 Identify how changes in volume affect costs.
 Use CVP analysis to compute breakeven point.
 Use CVP analysis for profit planning and graph the
cost-volume-profit relations
 Use CVP method to perform sensitivity analysis.
Contribution Margin
 Contribution margin is equal to the difference between total revenue and total
variable costs
Contribution margin per unit
= Selling price - Variable cost per unit
Contribution margin percentage
= Contribution margin per unit / selling price per unit

Total for
Per Unit 2 units %

Revenue 200400 100%


Variable costs 120240 60%
Contribution margin 80160 40%
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Contribution Margin
Income Statement
Sales
- Variable Costs
Contribution Margin
- Fixed Costs
Operating Income

Sales (20,000 x 85) 1,700,000


Variable costs
(20,000 x 70) (1,400,000)
Contribution margin 300,000
Contribution Margin
Income Statement
 Income statement that groups line items by cost behavior to highlight the contribution margin

Packages Sold

0 12 2540
Revenue 0200 4005,0008,000
Variable costs 0120 2403,0004,800
Contribution margin 080 1602,0003,200
Fixed costs 2,0002,0002,000 2,0002,000
Operating income (2,000)(1,920)(1,840) 01,200
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Computing Break-Even
Point

The unique sales level at which a


company earns neither a profit nor
incurs a loss.

Sales – Variable Costs – Fixed Costs = 0


Breakeven Point
 Quantity of output where total revenues equal total costs
 Point where operating income equals zero

Breakeven point in units


= Fixed costs / Contribution margin per unit
= 2,000 / 80
= 25 units

Breakeven point in Rupees


= Fixed costs / contribution margin %
= 2,000 / 40%
= 5,000 RS.

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Margin Of Safety
 Excess of actual or budgeted sales over
the break – even sales is known as MOS

MOS = Total Sales - sales at BEP


It can be improved by taking the following
steps:
1. By increasing the level of production or
selling price
2. By reducing fixed or variable cost.
Angle of Incidence
 Is the angle between the sales line and the
total cost line formed at the break even point
where the sales line and the total cost line
intersects each other. It indicates the profit
earning capacity of a business.
 A Large angle of incidence indicate a high
rate of profit and a small angle of incidence
indicates a low rate of profit
Types of
Costs

Variable

Fixed

Mixed
Total Variable Cost
Total variable costs change
when activity changes.
Total Long Distance

Your total long distance


Telephone Bill

telephone bill is based


on how many minutes
you talk.

Minutes Talked
Variable Cost Per Unit
Variable costs per unit do not change
as activity increases.
The cost per long

Telephone Charge
distance

Per Minute
minute talked is
constant.
For example, 2 Rs. per
minute.

Minutes Talked
Total Fixed Cost
Total fixed costs remain unchanged
when activity changes.
Telephone Bill
Monthly Basic

Number of Local Calls


Variable Costs
Example
24 –
18 –
12 –
6 –
) s dnas uo ht(
ai r a Vl at o T


0 1 2 3 4 5
Volume
(Thousands of passengers)
Mixed Costs
 Contain fixed portion that is incurred
even when facility is unused & variable
portion that increases with usage.
 Example: monthly electric utility
charge
 Fixed service fee
 Variable charge per kilowatt hour used
Mixed Costs
Total Utility Cost

ost
d c Variable
i xe
l m Utility Charge
o ta
T
Fixed Monthly
Utility Charge
Activity (Kilowatt Hours)
Preparing a CVP Chart
➊ Plot total fixed costs on the vertical axis.
Costs and Revenue

Total fixed costs


in Dollars

Total costs

Draw the total cost line with a slope


equal to the unit variable cost.

Volume in Units
Preparing a CVP Chart
Starting at the origin, draw the sales line Sales
with a slope equal to the unit sales price.
Costs and Revenue

Total fixed costs


in Dollars

Total costs

Break-even
Point

Volume in Units
Various Sales Levels
Example
 What operating income is expected when
sales are 80,000 units?

Selling price (20/unit) 16,00,000


Less: Variable exp (10/unit) 8,00,000
Contribution 8,00,000
Less: Fixed cost 4,00,000
Operating profit 4,00,000
Computing Multiproduct
Break-Even Point
 Unit contribution margin is replaced
with contribution margin for a
composite unit.
 A composite unit is composed of
specific numbers of each product in
proportion to the product sales mix.
 Sales mix is the ratio of the volumes
of the various products.
Computing Multiproduct
Break-Even Point
The resulting break-even formula
for composite unit sales is:

Break-even point Fixed costs


= Contribution margin
in composite units
per composite unit
Computing Multiproduct
Break-Even Point
Step 2: Compute break-even point in
composite units.
Break-even point Fixed costs
= Contribution margin
in composite units
per composite unit
900,000
Break-even point =
in composite units 450 per composite
unit
Break-even point = 2,000 composite units
in composite units
Computing Multiproduct
Break-Even Point
A company sells windows and doors.
They sell 4 windows for every door.

Windows Doors
Selling Price $200 $500
Variable Cost 125 350
Unit Contribution $ 75 $ 150
Sales Mix Ratio 4 1
Computing Multiproduct
Break-Even Point
Step 1: Compute contribution margin per
composite unit.
Windows Doors
Selling Price $200 $500
Variable Cost 125 350
Unit Contribution $ 75 $ 150
Sales Mix Ratio
Composite C/M
Computing Multiproduct
Break-Even Point

Step 3: Determine the number of windows and


doors that must be sold to break even.

Sales Composite
Product Mix Units Units
Window 4 × 2,000 = 8,000
Door 1 × 2,000 = 2,000
Multiproduct Break-Even
Income Statement
Step 4: Verify the results.

W indow s Doors Com bine d


Se lling Price $200 $500
Va ria ble Cost 125.00 350.00
Unit Contribution $ 75.00 $ 150.00
Sa le s Volum e × 8,000 × 2,000
Tota l Contribution $ 600,000 $ 300,000 $ 900,000
Fix e d Costs 900,000
Incom e $ 0