CVP Analysis

Cost-volume-profit analysis looks primarily at the effects of differing levels of activity on the
financial results of a business

In any business, or, indeed, in life in general, hindsight is a beautiful thing. If only we could look into
a crystal ball and find out exactly how many customers were going to buy our product, we would be
able to make perfect business decisions and maximize profits.
Take a restaurant, for example. If the owners knew exactly how many customers would come in
each evening and the number and type of meals that they would order, they could ensure that
staffing levels were exactly accurate and no waste occurred in the kitchen. The reality is, of course,
that decisions such as staffing and food purchases have to be made on the basis of estimates, with
these estimates being based on past experience. 
While management accounting information can’t really help much with the crystal ball, it can be of
use in providing the answers to questions about the consequences of different courses of action.
One of the most important decisions that need to be made before any business even starts is ‘how
much do we need to sell in order to break-even?’
By ‘break-even’ we mean simply covering all our operating costs without making a profit.
Prior Knowledge Formulas

Contribution per unit = unit selling price – unit variable costs

Profit = (sales volume × contribution per unit) – fixed costs

Breakeven point
(Activity level at which there is neither profit nor loss) = total fixed costs/ contribution per unit

Contribution/sales (C/S) ratio = (contribution/sales) × 100

Sales revenue at breakeven point = (fixed costs) / (C/S ratio)

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

Margin of safety (as %) = ((budgeted sales – breakeven sales)/ budgeted sales) × 100%

Sales volume to achieve a target profit = (fixed cost + target profit)/ contribution per unit

Example 1:
The following data relate to Product PQ:
Selling price £25perunit
Variable cost £20perunit
Fixed costs are £50,000.
Required:
 a) Calculate the number of units that must be made and sold in order to break even.
b) Calculate the level of activity that is required to generate a profit of £40,000.
c) The company budgets to sell 13,000 units of Product PQ. Calculate the margin of safety.
d) Calculate the Contribution/Sales ratio for Product PQ.
e) Calculate the breakeven point again, this time expressed in terms of sales revenue.
f) Calculate the sales revenue that is required to generate a profit of £40,000.

Example 2:
A company makes and sells a single product. The selling price is $12 per unit. The variable cost of
making and selling the product is $9 per unit and fixed costs per month are $240,000.
The company budgets to sell 90,000 units of the product a month.
Required
(a) What is the budgeted profit per month and what is the breakeven point in sales?
(b) What is the margin of safety?
(c) What must sales be to achieve a monthly profit of $120,000?

Single Product Breakeven Charts

For Breakeven Chart draw the following lines;

 Fixed cost
 Total cost
 Total Revenue

For Contribution Chart draw the following lines;

 Total Variable Cost
 Total Revenue
 Total Cost

For Profit and Volume Chart draw the following lines;

 Profit/Loss

For all of these Graphs, take costs, revenues, profit/ loss on y-axis whereas output on x-axis.

Example 3:
A new product has the following sales and cost data.
Selling price $60 per unit
Variable cost $40 per unit
Fixed costs $25,000 per month
Forecast sales 1,800 units per month
Required
Prepare breakeven, contribution and Profit/ Volume charts using the above data.

Example 4:
A company manufactures Product RS. The following data are available:
Selling price: $100 per unit
Variable cost: $60 per unit.
Fixed costs are $250,000. The company budgets to produce 12,000 units in the next period.
Required:

(a) Scenario I – Calculate:

(i) The breakeven point (expressed in units and $ of revenue).
(ii) The level of activity required to generate a profit of $90,000 (expressed in units).
(iii) The margin of safety as a percentage.
(b) Using graph paper, draw a profit volume chart for scenario I.

(c) Scenario II – Using the graph drawn in (b), illustrates and explain the impact of a change in
Selling Price to $120 per unit, on:
(i) The breakeven point (expressed in units and $ of revenue);
(ii) The level of activity required to generate a profit of $90,000 (expressed in units);
(iii) The margin of safety.

Breakeven analysis in a multi-product environment

The basic breakeven model can be used satisfactorily for a business operation with only one product.
However, most companies sell a range of different products, and the model has to be adapted when
one is considering a business operation with several products.
CVP Analysis assumes that, if a range of products is sold, sales will be in accordance with a pre-
determined sales mix.

The calculation of breakeven point in a multiproduct firm follows the same pattern as in a single
product firm. While the numerator will be the same fixed costs, the denominator now will be the
weighted average contribution margin.

In multiproduct situations, a weighted average C/S ratio is calculated by using the formula:

Total Contribution
Weighted Average C/S ratio = —————————
Total Revenue

The Weighted Average C/S ratio is useful in its own right, as it tells us what percentage each $ of
sales revenue contributes towards fixed costs; It is also invaluable in helping us to quickly calculate
the breakeven point in sales revenue:

Fixed costs
Breakeven revenue = —————————————
Weighted Average C/S ratio

Fixed costs
Breakeven units = —————————————
Weighted Average Contribution per unit

Example 5:
Company A produces Product X and Product Y. Fixed overhead costs amount to $200,000 every year.
The following budgeted information is available for both products for next year:
Product X Product Y
Sales Price $50 $60
 Variable Cost $30 $45
Contribution per unit $20 $15
Budgeted Sales (in units) 20,000 10,000
Calculate the breakeven revenue?

Example 6:
Breakeven point for multiple products
PL produces and sells two products, M and N. Product M sells for $7 per unit and has a total variable
cost of $2.94 per unit, while Product N sells for $15 per unit and has a total variable cost of $4.40 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 per period total $123,600.
Required
Calculate the breakeven point for PL.

Example 7:
H Limited manufactures and sells two products – J and K. Annual sales are expected to be in the ratio
ofJ:1 K:3. Total annual sales are planned to be £420,000. Product J has a contribution to sales ratio of
40% whereas that of product K is 50%. Annual fixed costs are estimated to be £120,000.

Required:
What is the budgeted breakeven sales value?

Example 8:
PER plc sells three products. The budgeted fixed cost for the period is£648,000. The budgeted
contribution to sales ratio (C/S ratio) and sales mix are as follows:

Product C/S ratio Mix

P 27% 30%
E 56% 20%
R 38% 50%
Required:
What is the breakeven sales revenue?

Establishing a Target Profit for Multiple Products

The approach is the same as in single product situations, but the weighted average contribution to
Sales Ratio is now used so that:

Fixed costs + required profit

Target Profit =
Weighted Average C/S ratio

Example 9:
For the above example, calculate the breakeven point if A company requires a minimum of $300,000
profit.
Margin of Safety Calculations
The basic breakeven model for calculating the margin of safety can be adapted to multiproduct
environments. Calculating the margin of safety for multiple products is exactly the same as for single
products, but we use the standard mix. The easiest way to see how it's done is to look at an example
below:

Example 10:
Murray Ltd produces and sells two types of sports equipment items for children, balls (in batches)
and miniature racquets.
A batch of balls sells for $8 and has a variable cost of $5. Racquets sell for $4 per unit and have a unit
variable cost of $2.60.
For every 2 batches of balls sold, one racquet is sold. Murray budgeted fixed costs are $407,000 per
period. Budgeted sales revenue for next period is $1,250,000 in the standard mix.
Calculate the margin of safety of Murray ltd.

The Multi Product Profit Volume Graph

Example 11: Output in $ sales and a constant product mix.
For example, suppose that FA sells three products, X, Y and Z which have variable unit costs of $3, $4
and$5 respectively. The sales price of X is $8, the price of Y is $6 and the price of Z is $6. Fixed costs
per annum are $10,000.
Assume that budgeted sales are 2,000 units of X, 4,000 units of Y and 3,000 units of Z. A breakeven
chart would make the assumption that output and sales of X, Y and Z are in the proportions 2,000:
4,000: 3,000 at all levels of activity, in other words that the sales mix is 'fixed' in these proportions.
Required:
Prepare breakeven, contribution and profit volume charts for multiple products.

Example 12:
Hair Co manufactures three types of electrical goods for hair: curlers (C), straightening irons (S) and
dryers (D.) The budgeted sales prices and volumes for the next year are as follows:
C S D
Selling price $110 $160 $120
Units 20,000 22,000 26,000
Each product is made using a different mix of the same materials and labour. Product S also uses
new revolutionary technology for which the company obtained a ten-year patent two years ago. The
budgeted sales volumes for all the products have been calculated by adding 10% to last year’s sales.
The standard cost card for each product is shown below.
C S D
$ $ $
Material 1 12 28 16
Material 2 8 22 26
Skilled labor 16 34 22
Unskilled labor 14 20 28
Both skilled and unskilled labor costs are variable.
The general fixed overheads are expected to be $640,000 for the next year.

Required:
(a) Calculate the weighted average contribution to sales ratio for Hair Co.
(b) Calculate the total break-even sales revenue for the next year for Hair Co.
(c) Using the graph paper, draw a multi-product profit-volume (PV) chart showing clearly the
profit/loss lines assuming:
(i) You are able to sell the products in order of the ones with the highest ranking contribution to
sales ratios first; and
(ii) You sell the products in a constant mix.
(d) Briefly comment on your findings in (c)

LIMITATIONS OF COST-VOLUME-PROFIT ANALYSIS

 Cost-volume-profit analysis is invaluable in demonstrating the effect on an organisation that

changes in volume (in particular), costs and selling prices, have on profit. However, its use is
limited because it is based on the following assumptions: Either a single product is being sold
or, if there are multiple products, these are sold in a constant mix. But if the constant
mix assumption changes, break-even point also gets changed.
 All other variables, apart from volume, remain constant, i.e. volume is the only factor that
causes revenues and costs to change. In reality, this assumption may not hold true as, for
example, economies of scale may be achieved as volumes increase. Similarly, if there is a
change in sales mix, revenues will change. Furthermore, it is often found that if sales
volumes are to increase, sales price must fall.
 The total cost and total revenue functions are linear. This is only likely to hold a short-run,
restricted level of activity.
 Costs can be divided into a component that is fixed and a component that is variable. In
reality, some costs may be semi-fixed, such as telephone charges, whereby there may be a
fixed monthly rental charge and a variable charge for calls made.
 It assumes that production volumes are equal to sales volumes.

Advantages of CVP Analysis

 Graphical representation of cost and revenue data can be more easily understood by non-
financial managers.
 A breakeven model enables profit or loss at any level of activity within the range for which
the model is valid to be determined, and
 The C/S ratio can indicate the relative profitability of different products.
 Highlighting the breakeven point and the margin of safety gives managers some indication of
the level of risk involved.