COST ACCOUNTING

CVP ANALYSIS (BREAKEVEN ANALYSIS)

What is CVP (break-even analysis?

CVP (cost-volume-profit analysis) uses a marginal costing approach to determine the relationship
between the level of activity and costs and revenues.

CVP analysis is a technique which uses cost behavior to identify the level of activity at which we
have no profit or loss (break-even point).

The CVP (cost-volume-profit) model is a useful tool for businesses to make decisions related to
pricing, production volume, and cost management.

Some of the specific benefits of using the CVP model include:

1. Understanding breakeven point: The CVP model can help a business determine the volume of
sales necessary to cover all costs and reach a breakeven point. By understanding the breakeven
point, a business can make informed decisions about pricing and sales volume needed to make
a profit.
2. Setting pricing: The CVP model can help a business set prices based on desired profit margins
and production volumes. By analyzing the impact of changes in price and volume on the profit
margin, a business can determine the most profitable pricing strategy.
3. Evaluating cost structure: The CVP model can help a business identify fixed and variable costs
and determine the contribution margin. This can help a business make decisions about cost
management and optimize its cost structure.
4. Assessing profitability: The CVP model can help a business evaluate the profitability of
different products or services by analyzing the contribution margin and breakeven point. This
can help a business make informed decisions about which products or services to focus on and
invest in.
5. To find risk level in sales plan (margin of safety). Margin of safety indicates the level of sales
that a business can tolerate before it reaches the breakeven point. The margin of safety is
important because it shows the cushion that a business has in case of unexpected decreases in
sales or increases in costs. The higher the margin of safety, the more resilient a business is to
these changes.
The margin of safety can be calculated using the following formula:
Margin of Safety = Budgeted Sales - Breakeven Sales
6. Allocation of resource in order of priority (constraints)
7. To determine sales plans to achieve a target profit

1|Page
COST ACCOUNTING

Single Product Environment

There are a number of key concepts within CVP analysis.

Breakeven point

This is the number of units which must be produced and sold in order for the company to break
even. ‘Breaking even’ means that all costs are covered, but profits are exactly zero.

So at this point, the total revenue equals the total costs.

Margin of Safety

The margin of safety indicates by how much sales can decrease before a loss occurs.

Target Sales volumes

If the company wishes to earn a profit of a certain amount, CVP can be used to determine how
many units must be produced and sold in order to achieve the target.

Contribution to sales ratio (CS Ratio)

This is calculated for each product. The CS Ratio indicates what % of the selling price actually
contributes towards covering fixed costs.

2|Page
COST ACCOUNTING

Formulae required (not given in the exam)

1. Unit contribution = Selling price – Variable cost/unit

2. Total contribution = Unit contribution x sales volume
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
3. Breakeven point (units) =
𝑈𝑛𝑖𝑡 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑆𝑎𝑙𝑒𝑠−𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡
4. Margin of Safety = x 100%
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑆𝑎𝑙𝑒𝑠
5. Contribution target = Total Fixed costs + Target Profit
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑡𝑎𝑟𝑔𝑒𝑡
6. Volume target =
𝑈𝑛𝑖𝑡 𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑈𝑛𝑖𝑡 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
7. CS Ratio = or
𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒
𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
8. Breakeven Sales Revenue =
𝐶𝑆 𝑅𝑎𝑡𝑖𝑜

Example

A company produces and sells one product, Product Z. The following budgeted information is
available:

Product Z
$
Selling price per unit 50
Variable cost per unit 30
Contribution per unit 20
Fixed Costs (Total) 200,000
Budgeted sales volume 15,000
Budgeted profit 100,000

Required:

(a) Calculate the following:

- Breakeven point (units)
- Margin of safety
- CS Ratio for Product Z
(b) If the company wants profits to increase to $ 250,000, calculate how many units would
need to be produced and sold to achieve this target.

3|Page
COST ACCOUNTING

Profit/Volume Chart

A breakeven chart shows the costs and revenues at a number of activity levels. It does not however,
show the amount of profit or loss at these levels. This is shown on the profit/volume chart.

From this chart we can read off the amount of profit or loss for any level of activity.

4|Page
COST ACCOUNTING

1. The x-axis represents sales (units or revenue)

2. The y-axis shows profits above the x-axis and losses below.
3. When sales equals zero, the net loss is equal to the fixed costs.
4. If contribution per unit and total fixed costs are constant throughout the relevant range, the
profit/volume chart is shown as a straight line.

Multi-Product Environment
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
Break even Sales Revenue ($) = 𝐶
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜
𝑆

𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
Weighted Average C/S Ratio =
𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠
Break even Sales unit =
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

Assumption of CVP Analysis:

The CVP (cost-volume-profit) model is based on certain assumptions, which include:
1. Fixed costs: The CVP model assumes that the total fixed costs of a business remain constant
over the relevant range of sales volume. In other words, fixed costs do not change with
changes in sales volume.
2. Linear costs: The CVP model assumes that variable costs are linear and vary in direct
proportion to changes in sales volume. This means that the variable cost per unit remains
constant.
3. Constant selling price: The CVP model assumes that the selling price per unit remains
constant regardless of changes in sales volume.
4. Single product or constant sales mix: The CVP model assumes that the business sells only one
product or that the sales mix of multiple products remains constant. This means that the
contribution margin ratio remains constant.
5. Short-term horizon: The CVP model assumes that the time horizon for analysis is short-term,
usually one year or less. This means that changes in market conditions or business operations
beyond the short-term period are not considered.
6. No inventory changes: The CVP model assumes that there are no inventory changes during the
analysis period. This means that the cost of goods sold is equal to variable costs.

It's important to keep in mind these assumptions when using the CVP model to make informed
business decisions. While these assumptions may not hold true in all situations, the CVP model
can still provide valuable insights into a business's operations and profitability.

5|Page
 COST ACCOUNTING

Limitations of CVP Model

While the CVP (cost-volume-profit) model can be a useful tool for analyzing a business's
operations and profitability, it has certain limitations that should be considered. Some of these
limitations include:
1. Limited applicability: The CVP model may not be applicable to all types of businesses or
industries. It is best suited for businesses with a single product or a constant sales mix, and
may not be effective for businesses with multiple products or services.
2. Simplistic assumptions: The CVP model is based on a number of assumptions, such as
fixed costs and linear variable costs, that may not hold true in all situations. This can limit
the accuracy and usefulness of the model in certain circumstances.
3. Short-term focus: The CVP model is typically used to analyze short-term profitability,
usually one year or less. This may not provide a complete picture of a business's long-term
sustainability or growth potential.
4. Limited cost information: The CVP model relies heavily on cost data, such as fixed and
variable costs, which may be difficult to accurately estimate or track in practice. This can
limit the accuracy and usefulness of the model's output.
5. Ignoring non-financial factors: The CVP model does not consider non-financial factors,
such as changes in market demand or shifts in consumer preferences, which can have a
significant impact on a business's profitability.

Overall, while the CVP model can be a useful tool for decision-making in certain circumstances,
it's important to consider its limitations and use it in conjunction with other analysis tools to make
informed business decisions.

Review Question
Mwamzandi is a poultry rearing village chicken for eggs at his 5-acre farm 5 kilometres outside of
Babati Town. He has a good market in Babati. He sells a tray of eggs at an average of Tshs 10,000
and the variable costs per tray amounts to Tshs 7,000. Total fixed costs for the farm amount to Tshs
6,000,000 per year. At the moment, his chicken produce 30 trays of eggs per day.

Required:
a) Calculate the breakeven point in trays and in shillings.
b) Mwamzadi wants a profit of Tshs 30,000,000, how many types of eggs should he produce
and sell?

6|Page