Introductory

Management Accounting

Lecture 4 &5

CVP Analysis

ChunLei Yang
 Lecture plan

Lecture 4:
1. Terms and definitions
2. Different Costs Classification for different purposes
3. The behaviour of costs: Variable vs. Fixed Costs

Lecture 5:
4. Break-even analysis
5. Contribution Margin

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1. Terms and definitions

Definition of cost

• Cost – the monetary value of the resources sacrificed to

achieve a specific objective

• Cost Object – anything for which a separate

measurement of costs is desired:

Product – a bicycle
Service – an airline flight from Manchester to Rome
Project – an airplane assembled by Airbus for Boeing
Activity – a test to determine the quality of a car
Department – the resources consumed by the marketing dept.
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2. Different Costs Classification for different purposes

Different Costs Classification for different purposes

•Managerial decision making

Relevant costs and irrelevant costs
•Cost behavior in relation to Output
Fixed and Variable Costs
•Assignment to Cost Object
Direct and Indirect Costs
•Financial statement perspective
Product (capitalized) and Period Costs
•Business Function
Manufacturing (raw material, labor, other manufacturing costs)
Non-Manufacturing: (marketing, distribution, customer service, legal)

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3. The behaviour of costs: Variable vs. Fixed Costs

The Behaviour of Costs

• The relationship between the incidence of cost and
the volume of output

• Depending on whether costs change according to the

volume of activities, four classes of cost behaviour

• Very important for planning and decision making-

CVP

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3. The behaviour of costs: Variable vs. Fixed Costs

Cost behavior in relation to output:

Fixed Costs
FIXED COSTS : Y=a
Costs that (in total) do not change with changes in the level of
production (output) over short periods of time.
Quarterly Fixed Costs (FC)

£20,000
15,000
FC = £10,000
10,000
5,000

0
0 200 400 600 800 1000
Quarterly Production (Q)
in thousands of gallons
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3. The behaviour of costs: Variable vs. Fixed Costs

Cost behavior in relation to output:

Fixed Costs

Examples of fixed costs include:

– Rent of buildings
– Salary paid to a supervisor
– Insurance and leasing of a plant
– Depreciation of a machine calculated on a
straight-line basis

Note: a fixed cost is by definition “unchanged” over a given

period of time, but it may vary in the longer term (where we
may change our production capacity, i.e. build another plant,
employ more supervisors, etc.)

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3. The behaviour of costs: Variable vs. Fixed Costs

Cost behavior in relation to output:

Fixed Costs

However… FIXED COSTS per unit of output decrease as

the level of production (output) increase
Quarterly Fixed Costs per Gallon

£0.0250 £0.0250

0.0200 0.0200
0.0167
0.0150 0.0143
0.0125
(FC/Q)

0.0100
0.0050

0
0 200 400 600 800 1000
Quarterly Production (Q)
in thousands of gallons 8
3. The behaviour of costs: Variable vs. Fixed Costs

Cost behavior in relation to output:

Variable Costs

VARIABLE COSTS : Y=bX

Costs that (in total) change in proportion to changes in the level of
production (output)
Quarterly Variable Costs(VC)

£40,000

30,000 VC = £0.0384 * Q £30,720

£26,880
in dollars

20,000 £23,040
£19,200
10,000 £15,360
Slope = 0.0384
0
500
200 400 600 800 1,000
Quarterly Production (Q)
in thousands of gallons 9
3. The behaviour of costs: Variable vs. Fixed Costs

Cost behavior in relation to output:

Variable Costs

Examples of variable costs include:

– Material used
– Labor costs
– Commission paid to a sales person

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3. The behaviour of costs: Variable vs. Fixed Costs

Cost behavior in relation to output:

Variable Costs
VARIABLE COSTS per unit of output are assumed to be
constant as the level of production (output) changes.

$0.05
Quarterly Variable Costs per Gallon

0.04

0.03

0.02
VC/Q = £0.0384 per gallon
(VC/Q)

0.01

0.00
0 200 400 600 800 1,000

Quarterly Production (Q)

in thousands of gallons
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3. The behaviour of costs: Variable vs. Fixed Costs

Cost behavior in relation to output:

Semi-variable costs

Semi-variable cost : Y=a+bX

A cost which is partially fixed and partially varies with the changes in
the level of quantity (activity). Examples: telephone costs—fixed basic
charge plus a variable element depending on the number of call-outs

Cost

Fixed cost
element
0
Volume of activity
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3. The behaviour of costs: Variable vs. Fixed Costs

Cost behavior in relation to Output:

Step costs

Step costs
A cost which is fixed over a certain range of production (quantity) but
then increases as the capacity (and the usage of a particular activity)
increases
Cost (C)

Relevant Range
Production Level (Q) 13
3. The behaviour of costs: Variable vs. Fixed Costs

Question
In a hospital setting, which cost element is likely to
vary according to patient days?

A. The cost of drugs and meals

B. The cost of MRI equipment
C. The cost of staff salary
D. The cost of utility bills

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4. Break-even analysis

Why study the behaviour of costs?

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4. Break-even analysis

The accountant's view

Cost-Volume-Profit Analysis

• Basic equations
Total costs of running a business = Fixed costs+ Variable costs
Total profit =Total Revenue-Total Costs

• The break-even point

The level of production (measured as sales volume) where total sales
and total costs are equal, so that there is neither profit nor loss.

• The margin of safety

The difference between the break-even sales and the normal level of
sales (measured in units or in £ of sales).

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4. Break-even analysis

Break-Even Analysis:
Graph of total costs against volume of activity

Graph of total cost against volume of

activity
Cost/
sales(£ ) TC = FC + VC (VC/unit * Q)

Variable costs

F
Fixed costs

0
Volume of activity (units of output)

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4. Break-even analysis

Break-Even Analysis:
Break-even chart

Break-even chart Total revenue

Cost/sales(£ )

BEP Total costs

Variable costs

F
Safety Fixed costs
margin
0
Volume of activity (units of output)

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4. Break-even analysis

Break-Even Analysis:
Profit-Volume chart

Profit

BEP

profit

Loss Volume of activity

FC

Loss

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 Lecture plan
Lecture 4:
• Terms and definitions
• Different Costs Classification for different purposes
• The behaviour of costs: Variable vs. Fixed Costs

Lecture 5:
• Break-even analysis
• Contribution Margin

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4. Break-even analysis

Deducing B-E-P
Total revenues=Total costs
That is,
Total revenues=Fixed Costs+ Total Variable Costs
If we call the output level at BEP Q, then
Q×Sales price=FC+ (b ×Variable costs per unit)
Thus,
Q × (Sales price-Variable costs per unit)=FC
Giving,
Total FC Total FC
Q= or,
Sales price-VC per unit Contribution margin

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4. Break-even analysis

CVP Analysis
The accountant's view - ASSUMPTIONS
ASSUMPTIONS USUALLY UNDERLYING CVP ANALYSIS:
• Linearity: Behind our previous discussions about cost
behaviour, we assume that most costs are linear—accountant’s
assumption. This is an acceptable assumption within a
particular range. Also confine discussions to a particular range.

– The selling price is either constant or varies in a linear fashion with

the quantity sold (i.e. a single product or a constant sales mix is
assumed).
– Costs can be easily divided into their fixed and variable elements.
– Unit variable costs will remain constant for all output levels (within
the relevant range).
– Fixed costs in total will remain constant for all output levels (within
the relevant range).
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4. Break-even analysis

CVP Analysis
The accountant's view - ASSUMPTIONS

ASSUMPTIONS USUALLY UNDERLYING CVP ANALYSIS:

• All goods produced are sold or alternatively there will be no
changes in finished stock levels.
• The product/service under consideration can be considered in
isolation, i.e. the impact of any other changes in the
organisation is not important.
• Resources are assumed to be in plentiful supply – hence there
are no constraints on production from scarce resources.
• The quality of the goods produced will be constant whatever
the output level.
• Taxation is usually ignored – in practice very important.

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4. Break-even analysis

Break-Even Analysis:
Break-even chart - The economist’s approach

£ TC
BEP

TR
BEP

0
Volume

Profit

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4. Break-even analysis

Cost-Volume-Profit Analysis
Relevant range

Total revenues

Total costs

Fixed costs

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4. Break-even analysis

Break-Even Analysis:
Break-even chart-the accountant’s approach

Break-even chart
Total revenue
Cost (£ ) Relevant range

BEP
Total costs

Variable costs

F
Fixed costs

0
Volume of activity (units of output)

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4. Break-even analysis

Cost-Volume-Profit Analysis
CVP analysis:
Example
Fixed costs per annum £ 60,000
Unit selling price £ 20 BREAK EVEN POINT
Unit variable cost £10 level of output
Relevant range 4,000 – 12,000 units at which TC = TR
Desired profit £40,000

• Break-even point (in units) = Fixed costs

Contribution per unit
= £60,000/£10 = 6,000 units (within the relevant range)

• Units to be sold to obtain a desired (£40 000) profit:

Fixed costs + desired profit = £100 000/£10 = 10 000 units
Contribution per unit
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5. Contribution Margin

Contribution Analysis
Contribution:
The bottom part of the break-even formula
Contribution Margin :
(in total) = TOTAL REVENUES – TOTAL VARIABLE COSTS
(per unit)= SELLING PRICE – VARIABLE COST PER UNIT
Interpretation:
what is left from the revenues after having covered the variable
costs...
(1) to cover the Fixed Costs, and
(2) “to get” some profit.

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5. Contribution Margin

Cost behavior in relation to Output:

Fixed Costs – Variable cost

Profit and Loss account

(Variable vs. fixed costs)
Revenues
- Variable manufacturing costs
- Variable nonmanufacturing costs

= Contribution margin
- Fixed manufacturing costs

- Fixed nonmanufacturing costs

= Profit (loss)
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5. Contribution Margin

Real life perspectives

Why do low cost airlines offer flights to customers at a

low price or even free?

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5. Contribution Margin

Illustration: CVP analysis-1

C Ltd makes T-shirts. The fixed
costs of operating the workshop
for a month total $500. Each T-
shirt requires materials that cost
$2; and takes 2 hrs to make. The A. 250
pay rate is $5 an hour. These T- B. 150
shirts are sold to a wholesaler C. 300
for $14 each. D. 200

Q: What is the BEP (in number of T-

shirts)?

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5. Contribution Margin

Illustration : CVP analysis-2

C Ltd (see illustration1) expects to sell 500 T-shirts a
month. The business has the opportunity to rent a
new sewing machine. Doing so would increase the
total fixed costs of operating the workshop for a
month to $3,000. using the machine would reduce
the labour time to one hr per T-shirt. Pay rate stays
the same $5/hr.

(1)How much profit would the business make each

month from selling T-shirts, assuming first that the
machine is rented, and then not rented?
(2) What is the BEP if the machine is rented?

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5. Contribution Margin

Solution notes
(a) without the machine with the machine

Sales (500*4) 7,000 7,000

Less materials (500*2) 1,000 1,000
labour (500*2*$5) 5,000
(500*1*$5) 2,500
Fixed costs 500 3,000

6,500
6,500
Profit 500
500

(b) The break even point (in number of T-shirts) with the machine:
= Fixed costs / (sales price-variable costs per unit)
= $3000/($14-(2+5))
=429 T-shirt per month

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5. Contribution Margin

Illustration: CVP analysis-3

Now assume the role of a consultant, what

advice would you give C Ltd about whether or
not it should rent the machine?

Operating leverage: FC vs. TC

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5. Contribution Margin

Solution notes

1. The economic consequences of automation

Without Machine With Machine

Effect on BEP 250 429

Effect on safety margin 50% (500-250/500) 14% (500-429/500)

Effect on contribution/unit 2 7

2. ‘Qualitative’ factors:
• Attitude towards risk-taking
• Market
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Real World Perspectives
What type of business tends to have higher operating gearing?
What are the implications for managing the business?

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Real life perspectives:
Understanding cost
structure in context

37
 Multi-Product CVP analysis
Coolpoint Ltd
Super wash

Smart wash

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 Multi-Product CVP analysis
Super wash Smart wash Total
Sales volume(units) 1200 600
Unit price 300 200
Unit VC 150 110
Unit contribution 150 90
TR 360,000 120,000 480,000
-total VC 180,000 66,000 246,000
Contribution to direct and common FC 180,000 54,000 234,000
-direct avoidable FC 90,000 27,000 117,000
Contribution to common FC 90,000 27,000 117,000
-common FC 39,000
Operating profit 78,000

Unit batch contribution: 150+150+90=390

BEP=(117000+39,000)/390 =400 batches800 super wash+400 smart wash
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 Multi-Product CVP analysis

Super wash Smart wash Total

Units sold 800 400

Unit contribution 150 90

Contribution to direct and common FC 120,000 36,000 156,000

-direct FC 90,000 27,000 117,000

Contribution to common FC 30,000 9,000 39,000

-common FC 39,000
Operating profit 0

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 Study checklist
• Understand the meaning of BEP and contribution analysis;

• Analyse cost and revenue behaviour to identify break-even

point and to make recommendations associated with changing
levels of activity.

• Understand the significance and implications of cost structure.

• Prepare Archaic for the next demonstration lecture; Prepare for

the next lecture on Full Costing (Atrill and McLaney, Chapter
4 and Chapter 5)
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