MANAGERIAL ACCOUNTING

COST VOLUME PROFIT ANALYSIS

Learning Objectives
explain the behavior of costs distinguish between fixed and variable costs understand and compute the break-even point discuss the key assumptions of CVP analysis apply CVP analysis to determine the effect on profit of changes in fixed expenses, variable expenses, sales price and sales volume. understand the implications of activity-based costing for CVP analysis

Cost Volume Profit Analysis

Chapter 7 Main Text Managerial Accounting Ronald Hilton, 8e, McGraw Hill

Introduction
Cost-volume-profit is a technique which summarizes the effects of changes in an organizations volume of activity on its costs, revenue and profit. Although the word profit appears in the term, costvolume-profit is not confined to profit-seeking enterprises. Managers in nonprofit organizations also routinely use CVP analysis to examine effects of activity and other short-run changes on revenue and costs.

COST BEHAVIOR
To understand CVP analysis, a first step is to distinguish variable costs from fixed costs. Cost accountants classify costs as variable or fixed depending on how much they change as the level of a particular cost driver changes. Before looking at Cost-Volume-Profit relationships it is important to understand the difference between fixed and variable costs.

Fixed vs. Variable Costs

The two basic types of cost-behaviour patterns found in many management accounting systems are the fixed and variable costs. The distinction between variable and fixed costs is necessary to address the basic questions, such as how much would manufacturing costs would change if the output level increases by 5%. Those costs which include both a fixed and variable element is called semi-variable costs.

Costs
Fixed costs Those costs which remain unchanged irrespective of the level of output (activity) in the short-term, within a relevant range. Variable costs Those costs which vary directly with the level of output (activity) in the short term, within a relevant range. Semi-variable costs Those costs which include both a fixed and a variable element. For instance, a production worker may be paid a fixed salary (the fixed element) and a bonus based upon output (the variable element).

Data required for effective CVP Analysis

CVP analysis relies on the interdependency of five components, or pieces of information: Sales price Volume Variable costs Fixed costs Profit or loss CVP helps managers discover how changes in any of these components will affect their business. Because business conditions are always changing, CVP helps mangers prepare for and respond to economic changes.

Cost-volume-profit (CVP) Analysis

Cost-volume-profit analysis is the study of the effects on future profits of changes in fixed cost, variable cost, sales price, quantity and mix (CIMA Terminology) A more common term used for this type of analysis is the break-even analysis.

The Break-Even Point

The first step in the CVP analysis is to find the breakeven point. The break-even point is the volume of activity where the organizations revenues and expenses are equal. At this point of sales, the organization has no profit or loss; it breaks even.

A Simple Illustration
Suppose Seattle Contemporary Theatre sells 8,000 tickets during a plays one month run. The following income statement shows that the profit for the month will be zero; thus the theatre will break-even. $ Sales revenue (8,000 *$16)128,000 Less Variable expenses (8,000 *$10). 80,000 Total contribution margin 48,000 Less: Fixed expenses.. 48,000 Profit....................................................... 0

Total Contribution Margin

The illustration (previous slide) highlights the distinction between variable and fixed expenses. It also shows the total contribution margin, which is defined as total sales revenue minus total variable expenses. This is the amount of revenue that is available to contribute to covering fixed expenses after all variable expenses have been covered.

Formulae for Breakeven Point

BEP (Without Target Profit) BEP (With Target Profit)

BEP (In Units) Total Fixed Costs Total Fixed Costs +Target Profit Contribution per unit Contribution per unit

BEP (In Value) Total Fixed Costs P/V Ratio*

Total Fixed Costs +Target Profit P/V Ratio*

*P/V Ratio = Contribution * 100 Sales

Assumptions Underlying CVP Analysis

The behavior of total revenue is linear (straight line). This implies that the price of the product or service will not change as sales volume varies within relevant range. The behavior of total expenses is linear (straight line). This implies the following specific assumptions. a.Expenses can be categorized as fixed, variable or semi variable. Total fixed expenses remain constant as activity changes, and the unit variable expense remains unchanged as activity changes. b.The efficiency and productivity of the production process and workers remain constant.

Assumptions Underlying CVP Analysis (Contd)

In multiproduct organizations, the sales mix remains constant over the relevant range. In manufacturing firms, the inventory levels at the beginning and end of the period are the same. This implies that the number of units produced during the period equals the number of units sold.

CVP analysis: non-graphical computations

Following data is available: Fixed costs per annum Unit selling price Unit variable cost Relevant range Break-even point Fixed costs Contribution per unit $60 000 $20 $10 4 000 - 12 000 units

= $60 000/$10 = 6 000 units

Units to be sold to obtain a $30 000 profit: = $90 000/$10 = 9 000 units Fixed costs + desired profit Contribution per unit

CVP analysis: non-graphical

If unit fixed costs and revenues are not given, the break-even point (expressed in sales values) can be calculated as follows: Total fixed costs x Total sales Total contribution Profit volume ratio = Contribution Sales revenue Percentage margin of safety = Expected sales - Break-even sales Expected sales x 100

Break-even chart

Contribution Chart

Profit-volume

Operating Leverage
To a physical scientist, leverage refers to the ability of small force to move a heavy object. To the managerial accountant, operating leverage refers to the ability of the firm to generate an increase in net income when sales revenue increases. The extent to which an organization uses fixed costs in its cost structure is called operating leverage. The operating leverage is greatest in firms with a large proportion of fixed costs, low proportion of variable costs, and the resulting high contributionmargin ratio.

Measuring Operating Leverage

The managerial accountant can measure a firms operating leverage, at a particular sales volume, using the operating leverage factor: Operating Leverage Factor = Contribution Margin Net Income

ABC provides a better understanding of Cost Behavior

Activity-based costing can provide a better understanding of an organizations cost behavior and CVP relationships than is provided by a traditional costing system. An ABC cost-volume-profit analysis recognises that some costs that are fixed with respect to sales volume may not be fixed with respect to other important cost drivers.