David Abbam Adjei

INSTITUTE OF CHARTERED

ACCOUNTANTS-GHANA

MANAGEMENT
ACCOUNTING

LECTURE 6:

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COST-VOLUME-
PROFIT ANALYSES

LECTURE LEARNING OBJECTIVES

1. Explain the nature of CVP analysis

2. Explain the Assumptions behind the CVP analysis
3. Calculate and interpret break-even point and margin of safety
4. Calculate the contribution to sales ratio, in single and multi-
product situations, and demonstrate an understanding of its
use
5. Calculate target profit or revenue in single and multi-product
situations, and demonstrate an understanding of its use
6. Prepare break even charts and profit volume charts and
interpret the information contained within each, including
multi-product situations
7. Discuss the limitations of CVP analysis for planning and
decision making

INTRODUCTION

Managers are concerned about the impact of their decisions on

profit. The decisions they make are about volume, pricing, or
incurring a cost. Therefore, managers require an understanding
of the relations among revenues, costs, volume, and profits. Cost-
volume-profit (CVP) analysis is a method for analysing how
operating decisions and marketing decisions affect profit based
on an understanding of the relationship between variable costs,
fixed costs, unit selling price, and the output level.
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A common term used for this type of analysis is breakeven

analysis. However, this is somewhat misleading, since it implies
that the focus of the analysis is the breakeven point – that is, the
level of activity which produces neither profit nor loss. You will
see in this chapter that the scope of CVP analysis is much wider
than this, as indicated in the definition. However, you should be
aware that the terms ‘breakeven analysis’ and ‘CVP analyses
tend to be used interchangeably.

CVP analysis is based on an explicit model of the relationships

among the three factors— costs, sales, and profits—and how they
change in a predictable way as the volume of activity changes.
The CVP model is Operating profit = Sales - Total costs, where
operating profit is profit exclusive of unusual or nonrecurring
items and is before tax. When there are no unusual or
nonrecurring items, operating profit is simply before-tax income.

Assumptions behind CVP Analysis

For CVP analysis to be useful, the assumptions on which it is

based must be recognised. These assumptions set the rules for
examining relationships between sales volume, costs and profits.
The conditions which are assumed to apply when CVP analysis is
used are presented below.

1. Relevant range: The company is assumed to be operating

within the relevant range of activity specified in determining
the revenue and cost information used in the CVP model;
2. Revenue: Total revenue fluctuates in direct proportion to the
level of activity or volume while revenue per unit is assumed
to remain constant, and fluctuations in per unit revenue for
factors such as quantity discounts are ignored;
3. Variable costs: Total variable costs fluctuate in direct
proportion to the level of activity or volume. Variable costs
per unit are assumed to remain constant within the relevant
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range. Variable production costs include direct material,

direct labour, and variable overhead; variable selling costs
include charges for items such as commissions and shipping;
and variable administrative costs may exist in areas such as
purchasing;
4. Fixed costs: Total fixed costs are assumed to remain constant
within the relevant range. Fixed cost per unit decreases as
volume increases, and it increases as volume decreases. Fixed
costs include both fixed factory overhead and fixed selling and
administrative expenses; and
5. Mixed costs: Mixed costs must be separated into their
variable and fixed elements before they can be used in CVP
analysis. Any method (such as High-Low method) that validly
separates these costs in relation to one or more predictors
may be used.
6. Only one product is being produced or there is a constant
sales mix. CVP analysis only applies where one product is
being examined or if there are a number of products then
they are always sold in same proportions or combination.
7. Total costs and total revenue are linear functions. This
assumption suggests that the variable cost per unit and the
selling price per unit do not change i.e., they are not affected
by discounts.
8. Profits are calculated using variable (marginal) costing.
Variable costing facilitates profit analysis as it separates
variable and fixed costs and treats fixed costs as a period
expense rather than attempting to allocate them to products.
9. No Inventory. CVP analysis assumes that all goods produced
are sold. There are no opening or closing inventory.
10. Costs can be accurately divided into their fixed and variable
elements. This is a key requirement of variable costing. The
suggestion is that where there are semi-variable costs, that
they can be accurately split by using techniques such as the
high-low method.
11. The analysis applies only to a short-term horizon. CVP
analysis examines the relationship between sales volume,
costs and profit during the period of one year and during this
time it is suggested that it would be difficult to change selling
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prices, variable and fixed costs which is in agreement with

the other assumptions above.

Methods for dealing with CVP Analysis

There are three related ways (we will call them methods) to think
more deeply about and model CVP relationships:

1. The equation method

2. The contribution margin method
3. The graph method

The equation method and the contribution margin method are

most useful when managers want to determine operating income
at few specific levels of sales (for example 5, 15, 25, and 40 units
sold). The graph method helps managers visualize the
relationship between units sold and operating income over a
wide range of quantities of units sold

The Equation and Contribution margin method

The equation and contribution margin methods use formulae to

calculate the break even points in units and cedi value and then
provide basis for further changes in the variables

Contribution per unit = unit selling price – unit variable costs

Breakeven point = activity level at which there is neither profit

nor loss

= Total Fixed Costs

Selling Price – Variable Cost

OR

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Contribution/sales (C/S) ratio = profit/volume (P/V) ratio

Sales revenue at breakeven point = Fixed Cost x SP

SP - VC

Or Fixed costs
C/S ratio

Margin of safety (in units) = budgeted sales units – breakeven

sales units

Budgeted sales – breakeven

Margin of safety (as ×
sales
%) 100%
Budgeted sales

Sales volume to achieve a target Fixed cost + target profit

profit Contribution per unit

Including Income Taxes in CVP Analysis

The manager’s decisions about costs and prices usually must
include income taxes because taxes affect the amount of profit
for a given level of sales. Thus, when taxes are considered, the
CVP model is as follows, where the average tax rate is t:

Fixed cost + target profit

Sales volume to achieve a
(1-t)
target profit
Contribution per unit

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CVP analysis has many applications:

Breakeven is the situation where total sales revenue for a period
just enough to cover fixed costs, leaving neither profit nor loss.
For every unit sold in excess of the breakeven point, profit
will increase by the amount of the contribution per unit.
The above has a lot of applications in business.

1. Setting prices for products and services, to determine the

break-even points and to make profits.
2. Introducing a new product or service. How to set prices to
determine the break-even points and how many units to be
sold
3. Replacing a piece of equipment.
4. Determining the breakeven point.
5. Deciding whether to make or buy a given product or service.
6. Determining the best product mix.
7. Performing strategic what-if analyses.

The Graphical Approach for Single Product

The third method to find the break-even is to use the graphical

method. The graphical method is based on the break-even chart,
a graphical representation of cost-volume-profit relationships and
the break-even point. It is an attempt to help management in
their understanding of these relationships and so enable them to
decide on the optimum level of output.

Drawing a basic breakeven chart

A basic breakeven chart records costs and revenues on the

vertical axis and the level of activity on the horizontal axis. Lines
are drawn on the chart to represent costs and sales revenue. The
breakeven point can be read off where the sales revenue line cuts
the total cost line.

A basic break-even chart is a chart or graph showing, for all

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volumes of output and sales:

1. Total costs, analysed between variable costs and fixed costs.

2. Total Sales
3. Profit (= the difference between total sales and total costs)
4. The break-even point (where total costs = total sales revenue,
and profit = 0).

The concept of a break-even chart is similar to a cost behaviour

chart, but with sales revenue shown as well.

If the chart also indicates the budgeted volume of sales, the

margin of safety can be shown as the difference between the
budgeted volume and the break-even volume of sales.

Example
A new product has the following sales and cost data.

Selling price GH¢60 per unit

Variable costs GH¢40 per unit
Fixed costs GH¢25,000 per
month

Forecast sales 1,800 units per month

Required:
Prepare a breakeven chart using the above data.

Solution:

Step 1
Draw the axes and label them. Your graph should fill as much of
the page as possible; this will make it clearer and easier to read.
The highest value on the vertical axis will be the monthly sales
revenue. 1,800 units x GH¢60 = GH¢108,000
Step 2
Draw the fixed cost line and label it. This will be a straight line
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parallel to the horizontal axis at the GH¢25,000 level. The GH

¢25,000 fixed costs are incurred even with zero activity.
Step 3
Draw the total cost line and label it. The best way to do this is to
calculate the total costs for the maximum sales level (1,800
units). Mark this point on the graph and join it to the cost
incurred at zero activity, that is, GH¢25,000.
GH¢
Variable costs for 1,800 units (1,800 x GH¢40) 72,000
Fixed costs 25,000
Total cost for 1,800 units 97,000
Step 4
Draw the revenue line and label it. Once again, start by plotting
the revenue at the maximum activity level. 1,800 units x GH¢60
= GH¢108,000. This point can be joined to the origin, since at
zero activity there will be no sales revenue.
Step 5
Mark any required information on the chart and read off
solutions as required. Check that your chart is accurate by
reading off the measures that we have already covered in this
chapter: the breakeven point, the margin of safety, the profit for
sales of 1,800 units.
Step 6
Check the accuracy of your readings using arithmetic. If you
have time, it is good examination technique to check your answer
and make adjustments for any errors in your chart.
The completed graph is shown below

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The contribution breakeven chart

One of the problems with the conventional or basic breakeven

chart is that it is not possible to read contribution directly from
the chart. A contribution breakeven chart is based on the same
principles but it shows the variable cost line instead of the fixed
cost line. The same lines for total cost and sales revenue are
shown so the breakeven point and profit can be read off in the
same way as with a conventional chart. However, it is possible
also to read the contribution for any level of activity.

The contribution can be read as the difference between the sales

revenue line and the
variable cost line. This form of presentation might be used when
it is desirable to highlight the importance of contribution and to
focus attention on the variable costs.

Breakeven Analysis for Multiple Products

Organisations typically produce and sell a variety of products and

services. To perform breakeven analysis in a multi-product
organisation, however, a constant product sales mix must be
assumed. In other words, we have to assume that whenever x
units of product A are sold, y units of product B and z units of
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product C are also sold.

Exercise

PL produces and sells two products. The M sells for GH¢7 per
unit and has a total variable cost of GH¢2.94 per unit, while the
N sells for GH¢15 per unit and has a total variable cost of GH
¢4.50 per unit. The marketing department has estimated that for
every five units of M sold, one unit of N will be sold. The
organization’s fixed costs total GH¢36,000.

Required:
Calculate the breakeven point for PL.

Solution:
1. Calculate contribution per unit
M N
GH¢ per unit GH¢ per
unit
Selling price 7.00 15.00
Variable cost 2.94 4.50
Contribution 4.06 10.50

2. Calculate contribution per mix GH¢

M = GH¢4.06 x 5 20.30
N = GH¢10.50 x 1 10.50
30.80

3. Calculate the breakeven point in terms of the number of

mixes
= Fixed costs
Contribution per mix

= GH¢36,000
GH¢30.80
= 1,169 mixes (rounded)

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4. Calculate the breakeven point in terms of the number of units

of products
M = (1,169 x 5) 5,845 units
N = (1,169 x 1) 1,169 units

5. Calculate the breakeven point in terms of revenue

GH¢
M = (5,845 x GH¢7) 40,915
N = (1,169 x GH¢15) 17,535
58,450

Contribution to sales (C/S) ratio for multiple products

The breakeven point in terms of sales revenue can be calculated

as
Fixed costs
Average C/S ratio.

Any change in the proportions of products in the mix will change

the contribution per mix and the average C/S ratio and hence the
breakeven point.

It should be noted that the C/S ratio is sometimes called the

profit/volume ratio or P/V ratio.

Margin of safety for multiple products

The margin of safety for a multi-product organisation is equal to

the budgeted sales in the standard mix less the breakeven sales
in the standard mix. It may be expressed as a percentage of the
budgeted sales.

Exercise
BA produces and sells two products. The W sells for GH¢8 per
unit and has a total variable cost of GH¢3.80 per unit, while the
R sells for GH¢14 per unit and has a total variable cost of GH
¢4.20. For every five units of W sold, six units of R are sold. BA's
fixed costs are GH¢43,890 per period.
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Budgeted sales revenue for next period is GH¢74,400, in the

standard mix.

Required:

Calculate the margin of safety in terms of sales revenue and also

as a percentage of budgeted sales revenues.

Solution:

1. Calculate contribution per unit

W R
GH¢ per unit GH¢ per
unit
Selling price 8.00 14.00
Variable cost 3.80 4.20
Contribution 4.20 9.80

2. Calculate contribution per mix

= GH¢4.20 x 5 + GH¢9.80 x 6 = GH¢79.80

3. Calculate the breakeven point in terms of the number of

mixes
= Fixed costs
Contribution per mix
= GH¢43,890
GH¢79.80
= 550 mixes

4. Calculate the breakeven point in terms of the number of units

of products
W = (550 x 5) 2,750 units
R = (550 x 6) 3,300 units
5. Calculate the breakeven point in terms of revenue
W = (2,750 x GH¢8) = GH¢22,000
R = GH¢22,000 = GH¢46,200
GH¢68,200
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6. Calculate the margin of safety

= budgeted sales – breakeven sales
= GH¢74,400 – GH¢68,200
= GH¢6,200 sales in total, in the standard mix

= GH¢6,200 / GH¢74,400 x 100%

= 8.3% of budgeted sales

Target profits for multiple products

The number of mixes of products required to be sold to achieve a

target profit is calculated as:

(Fixed costs + required profit)

Contribution per mix.

Exercise
An organisation makes and sells three products, F, G and H. The
products are sold in the proportions F:G:H = 2:1:3. The
organisation's fixed costs are GH¢80,000 per month and details
of the products are as follows.

Selling price Variable cost

Product GH¢ per unit GH¢ per unit
F 22 16
G 15 19
H 19 13

The organisation wishes to earn a profit of GH¢52,000 next

month. Calculate the required sales value of each product in
order to achieve this target profit.

Solution:
1. Calculate contribution per unit
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F G H
GH¢ per GH¢ per GH¢ per
unit unit unit
Selling price 22 15 19
Variable cost 16 12 13
Contribution 6 3 6

2. Calculate contribution per mix

= (GH¢6 x 2) + (GH¢3 x 1) + (GH¢6 x 3)
= GH¢33

3. Calculate the required number of mixes

= (Fixed costs + required profit)
Contribution per mix

= (GH¢80,000 + GH¢52,000)
GH¢33

= 4,000 mixes

4. Calculate the required sales in terms of the number of units of the

products and sales revenue of each product
Produ Units Selling price Sales revenue
ct required
GH¢ per unit GH¢
F 4,000 x 8,000 22 176,000
2
G 4,000 x 4,000 15 60,000
1
H 4,000 x 12,000 19 228,000
3
Total 464,000

The sales revenue of GH¢464,000 will generate a profit of GH

¢52,000 if the products are sold in the mix 2:1:3.

Alternatively, the C/S ratio could be used to determine the

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required sales revenue for a profit of GH¢52,000.

Solution:

1. Calculate revenue per mix

= (2 x GH¢22) + (1 x GH¢15) + (3 x GH¢19)
= GH¢116

2. Calculate contribution per mix

= (GH¢6 x 2) + (GH¢3 x 1) + (GH¢6 x 3)
= GH¢33

3. Calculate average C/S ratio

= (GH¢33/GH¢116) x 100%
= 28.45%

4. Calculate the required total revenue

= required contribution ÷ C/S ratio
= (GH¢80,000 + GH¢52,000) ÷ 28.45%
= GH¢463,972

5. Calculate revenue ratio of mix

= (2 x GH¢22) : (1 x GH¢15) : (3 x GH¢19)
= 44 : 15 : 57

6. Calculate required sales

Required sales of F = 44/116 x GH¢463,972 = GH¢175,989

Required sales of G = 15/116 x GH¢463,972 = GH¢59,996
Required sales of H = 57/116 x GH¢463,972 = GH¢227,986

Which, allowing for roundings, is the same answer as calculated

in the first example.

Strategic role of CVP

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CVP analysis can help a firm execute its strategy by providing an

understanding of how changes in its volume of sales affect costs
and profits. Many firms, especially cost leadership firms, compete
by increasing volume (often through lower prices) to achieve
lower overall operating costs, particularly lower unit fixed costs.
CVP analysis provides a means to predict the effect of sales
growth on profits. It also shows the risks in increasing fixed costs
if volumes fall.
Strategic questions answered by CVP

1. What is the expected level of profit at a given sales volume?

2. What additional amount of sales is needed to achieve a
desired level of profit?
3. What will be the effect on profit of a given increase in sales?
4. What is the required funding level for a governmental agency,
given desired service levels?
5. Is the forecast for sales consistent with forecasted profits?
6. What additional profit would be obtained from a given
percentage reduction in unit variable costs?
7. What increase in sales is needed to make up a given decrease
in price to maintain the present profit level?
8. What sales level is needed to cover all costs in a sales region
or product line?

Limitations of CVP Analysis:

The limitations of the practical applicability of breakeven analysis

and breakeven charts stem mostly from the assumptions that
underlie the analysis:

1. Costs are assumed to behave in a linear fashion. Unit variable

costs are assumed to remain constant and fixed costs are
assumed to be unaffected by changes in activity levels. The
charts can in fact be adjusted to cope with non-linear variable
costs or steps in fixed costs, but too many changes in
behaviour patterns can make the charts very cluttered and
difficult to use.

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2. Sales revenues are assumed to be constant for each unit sold.

This may be unrealistic because of the necessity to reduce the
selling price to achieve higher sales volumes. Once again, the
analysis can be adapted for some changes in selling price but
too many changes can make the charts unwieldy.
3. There is assumed to be no change in inventory. Production and
sales are assumed to be the same, so that the consequences of
any increase in inventory levels or of 'de-stocking' are ignored.
Reported profits can vary if absorption costing is used and
there are changes in inventory levels.
4. It is assumed that activity is the only factor affecting costs, and
factors such as inflation are ignored. This is one of the reasons
why the analysis is limited to being essentially a short-term
decision aid.
5. Apart from the unrealistic situation of a constant product mix
where a range of products are sold but always in the same
ratio to one another, the charts can only be applied to a single
product or service. Not many organisations have a single
product or service, and if there is more than one then the
apportionment of fixed costs between them becomes arbitrary.
6. The analysis seems to suggest that as long as the activity level
is above the breakeven point, then a profit will be achieved. In
reality certain changes in the cost and revenue patterns may
result in a second breakeven point after which losses are
made.
7. It is assumed that fixed costs are the same in total and variable
costs are the same per unit at all levels of output. The
assumption is only correct within a normal range or relevant
range of output. It is generally assumed that both the
budgeted output and the breakeven point lie within this
relevant range. This assumption is a great simplification.
a. Fixed costs will change if output falls or increases
substantially (most fixed costs are step costs).
b. The variable cost per unit will decrease where economies
of scale are made at higher output volumes, but the
variable cost per unit will also eventually rise when
diseconomies of scale begin to appear at even higher
volumes of output (for example the extra cost of labour in
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overtime working).

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