Cost-Volume-Profit (CVP) Analysis

In marginal costing, marginal cost varies directly with the volume of production or output. On
the other hand, fixed cost remains unaltered within the relevant range. Thus, if volume is
changed, variable cost will vary in proportion to the volume. In this case, selling price remains
fixed, fixed cost remains fixed which translates to a change in profit.

Managers constantly strive to relate these elements in order to achieve maximum profit. Apart
from profit projection, the concept of Cost-Volume-Profit (CVP) is relevant to virtually all
decision-making areas, particularly in the short run.

The relationship among cost, revenue and profit at different levels of output may be expressed in
graphs such as break-even charts, profit volume graphs, or in various statement forms.

Profit depends on a large number of factors, most important of which are the cost of
manufacturing and the volume of sales. Both these factors are interdependent. Volume of sales
depends upon the volume of production and market forces which in turn is related to costs.
Management has no control over market. In order to achieve certain level of profitability, it has
to exercise control and management of costs, mainly variable cost. This is because fixed cost is a
non-controllable cost and is irrelevant for decision making where it is not changed by the course
of action taken.

But then, cost is determined by various factors which include:

• Material prices, wage rates and overhead costs may all change because of the
impact
of inflation

• Material usage may change where scrap is expected to fall because of improved
methods, better trained workers or better material quality.

• Labor efficiency may change where improved training programs or a reduction in

labour turnover is expected to occur.

• Internal efficiency and the productivity of the factors of production; Overhead

expenses may fall due to more efficient placement of order with suppliers who offer
best terms
• Product volume of production or size of batches.
 • Product mix may change either as part of overall company strategy or due to
increased competition.

• Methods of production and technology.

• Size of plant.

Thus, one can say that cost-volume-profit analysis furnishes the complete picture of the profit
structure. This enables management to distinguish among the effect of sales, fluctuations in
volume and the results of changes in price of product/services.

In other words, CVP is a management accounting tool that expresses relationship among sale
volume, cost and profit. CVP can be used in the form of a graph or an equation. Cost-volume-
profit analysis can answer a number of analytical questions. Some of the questions are as
follows:

a) What is the break-even revenue of an organization?

b) How much revenue does an organization need to achieve a budgeted profit?

c) What level of price change affects the achievement of budgeted profit?

d) What is the effect of cost changes on the profitability of an operation?

Cost-volume-profit analysis can also answer many other “what if” type of questions. Cost-
volume profit analysis is one of the important techniques of cost and management accounting. It
provides an answer to “what if” theme by telling the volume required to produce. Cost and
revenues will change as well as sales revenue due to a number of factors. These are:

a) Increased competition may require selling price discounts in order to stimulate

demand

b) Material prices, wage rates and overhead costs may all change because of the
impact
of inflation

c) Material usage may change where scrap is expected to fall because of improved
methods, better trained workers or better material quality
 d) Labour efficiency may change where improved training programs or a reduction
in labour turn over is expected to occur

e) Overhead expenses may fall due to more efficient placement of order with
suppliers who offer best terms

f) Product mix may change either as part of overall company strategy or due to
increased competition
Following are the three approaches to a CVP analysis:
• Cost and revenue equations

• Contribution margin

• Profit graph

Objectives of Cost-Volume-Profit Analysis

a) In order to forecast profits accurately, it is essential to ascertain the relationship

between cost and profit on one hand and volume on the other.

b) Cost-volume-profit analysis is helpful in setting up flexible budget which

c) Cost-volume-profit analysis assists in evaluating performance for the purpose of control

thus enabling management to take corrective actions where necessary and in good
time.

d) Such analysis may assist management in formulating pricing policies by projecting the
effect of different price structures on cost and profit.

Assumptions and Terminology

CVP is based on various assumptions as listed below:

1. Volume is the only factor affecting sales and expenses The changes in the level of
various revenue and costs arise only because of the changes in the volume of output
produced and sold, e.g., bales of flour produced by Unga Ltd. The number of output
(units) to be sold is the only revenue and cost driver.
 indicates cost at various levels of activities.

2. Total costs can be divided into fixed and variable components. Variable
component will vary directly with level of output. Direct materials, direct labour and
direct chargeable expenses form the direct variable costs while variable part of factory
overheads, administration overheads and selling and distribution overheads form the
variable overheads.

3. There is linear relationship between revenue and cost.

4. The behavior of both sales revenue and expenses is linear throughout the entire
relevant range of activity. Graphically, it assumes a linear equation of the form Y=mX
+C

5. The unit selling price, unit variable costs and fixed costs are constant.

6. The theory of CVP is based upon the production of a single product. However, of
late, management accountants are functioning to give a theoretical and a practical
approach to multi-product CVP analysis.
7. There is only one product or service or a constant Sales Mix. The analysis either
covers a single product or assumes that the sales mix sold in case of multiple products
will remain constant as the level of total units sold changes.

8. All revenue and cost can be added and compared without taking into account the
time value of money.

9. The theory of CVP is based on the technology that remains constant.

10. The theory of price elasticity is not taken into consideration.

11. Inventories do not change significantly from period to period:

Many companies, and divisions and sub-divisions of companies in various industries have found
the simple CVP relationships to be helpful in Strategic and long-range planning decisions and
product features and pricing decisions

In real life, the assumptions described above may not hold. The theory of CVP can be tailored
for individual industries depending upon the nature and peculiarities of the same.
For example, predicting total revenue and total cost may require multiple revenue drivers and
multiple cost drivers. Some of the multiple revenue drivers are as follows:

• Number of output units

• Number of customer visits made for sales

• Number of advertisements placed

Some of the multiple cost drivers are as follows:

• Number of units produced

• Number of batches in which units are produced

The cost equation, for example, will be of the form;

Y = C + m1X1 + m2X2 + m3X3 + ... + mnXn

Managers and management accountants, however, should always assess whether the simplified
CVP relationships generate sufficiently accurate information for predictions of how total
revenue and total cost would behave. However, one may come across different complex
situations to which the theory of CVP would rightly be applicable in order to help managers to
take appropriate decisions under different situations.

Limitations of Cost-Volume Profit Analysis

The CVP analysis is generally made under certain limitations and with certain assumed
conditions, some of which may not occur in practice. Following are the main limitations and
assumptions in the cost-volume-profit analysis:

1. It is assumed that the production facilities anticipated for the purpose of cost-
volume profit analysis do not undergo any change. Such analysis gives misleading
results if expansion or reduction of capacity takes place, which in most cases does.

2. In case a variety of products with varying margins of profit are manufactured, it is

difficult to forecast with reasonable accuracy the volume of sales mix which would
optimize the profit.
 3. It assumes that input price and selling price remain fairly constant which in reality
is not the case. Thus, if cost or selling price changes, the relationship between cost and
profit will not be accurately depicted.

4. It assumes that variable costs are perfectly and completely variable at all levels of
activity and fixed cost remains constant throughout the relevant range. However, this
situation is not a practical one.

5. It is assumed that inventories do not change significantly from period to period.

However, in reality, opening inventory and closing inventory are never the same and in
most cases they vary significantly.

6. Inventories are valued at variable cost and fixed cost is treated as period cost.
Therefore, closing stock carried over to the next financial year does not contain any
component of fixed cost. Inventory should be valued at full cost in reality because such
costs were incurred to bring the inventory into existence..

The limitations of CVP analysis are actually its assumptions, which do not hold outside the
relevant range

Approaches to CVP

(i) Cost and revenue equations

From the marginal cost statements, the following equations can be derived:
Sales – Marginal cost = Contribution……………… (1)
Contribution – Fixed costs = Profit
∴Fixed cost + Profit = Contribution……………… (2)

From the above equations, we get the fundamental marginal cost equation as follows:

Sales – Marginal cost = Fixed cost + Profit ………. (3)

Rearranging the equation above to make profit the subject of the formula one will get

Profit = Sales – Marginal cost – Fixed cost………. (4)

Let the selling Price be P, Marginal cost per unit (variable cost per Unit) be V, Profit be J, level
of output be x and fixed costs be F
We have seen that sales and Marginal cost vary directly with output

From equation (4) above we obtain

Profit,π=(Selling Price,S - Variable cost,V)Output,x - Fixed cost,F

π =(S-V)x-F

Illustration
This is the basic equation used in cost volume profit analysis.

Assume the following situation:

Selling price per Unit Shs.2,000
Direct material unit cost Shs.600
Direct labor unit cost Shs.300
Variable manufacturing overhead Shs.200
Variable marketing Shs.250
Fixed manufacturing overhead Shs.500,000

Required:

Calculate the level of profits in the following independent situations.

1. The level of output 1000 units
2. The level of output is 750 units
3. The price falls to Shs.1900 and the level of output produced is 1,500.
4. Direct material unit cost falls to Shs.500, selling price falls to Shs.1900 and the
output produced rises to 1750 units

Solution
S = Shs.2,000
V= Shs. ( 600+300+200+250) = Shs.1,350
 F = Shs.500,000
1 At 100 units output level
π =(S-V)x-F
=(2,000-1,350)1,000!500,000
= 650 x 1,000 - 500,000
= 650,000 - 500,000
=1 50,000

2 At 750 units output level

π =(S-V)x-F
=(2,000 -1,350)750 - 500,000
= 650 x 750 - 500,000
= 487,500 - 500,000
=(12,500)

3 At Selling price of Shs.1900 and output of 1,500 units

π =(S-V)x-F
=(1,900-1,350)1500!500,000
= 550 x 1,500 - 500,000
= 825,000 - 500,000
= 325,000

4 At Selling price of Shs.1900 and output of 1,750 units,

π =(S-V)x-F
=(1,900 -1,250)1,750 - 500,000
= 650 x 1,750 - 500,000
=1,137,500 - 500,000
= 637,500

( ii) Contribution margin approach

The sales and marginal costs vary directly with the number of units sold or produced. So
contribution will bear a relation to sales, whether sales units or sales revenue, and the ratio of
contribution to sales remains constant at all levels.

From the equation (iii) given above

Sales – Marginal cost = Fixed cost + Profit ………. (3)
(S - V) x = F +Π
But (S – V) is the contribution margin per unit (CM), which is constant.
Therefore,
CM⋅x = F + π

To calculate the quantity, x that gives a specific profit, π one can make x the subject of the
formula by dividing both sides of the equation by the Contribution Margin per unit, CM

F+π
X=
CM

This equation is fundamental and is used as the basis for break-even analysis. One can work
with either approach (i) or (ii) of the CVP analysis to obtain the variable needed.

Note, we use the term „Profit Volume Ratio‟ in this context to refer to „Contribution Volume
Ratio‟. We use Contribution figure and not Profit figure to calculate this ratio.

One can also use Contribution Margin Ratio (CMR) in the CVP analysis. CMR is extremely
useful in that it shows how contribution margin will change in proportion to a given shilling
change in total sales. It is expressed as a percentage or as a ratio.

Total Contribution Contribution per Unit (CM) x Units sold(x)

CMR= =
Total sales Selling Price(P) x Units sold(x)

Contribution per Unit(CM)

=
Selling Price(P)
 CM
CMR =

Variable costs, just as sales revenue, vary directly with sales i.e. VC/S is constant.
This ratio is the Variable Cost Ratio, VCR. It can also be calculated by
subtracting the CMR from 1

i.e. VCR + CMR = 1

This can be justified as follows:

Sales – Variable costs = contribution

Make sales the subject of the formula to get;
Sales = Variable costs + Contribution
Divide through by the number of units sold to get
Selling price = Variable cost per unit + Contribution per Unit

Divide both sides of the equation by selling price to get;

Variable cost per Unit(VC) Contribution per Unit(CM)

1= +
Selling Price(P) Selling Price(P)
1 = VCR + CMR

From the approach above, the basic marginal equation in the first approach π =(S-V)x-F ,
has been modified to give the following two equations.
π = CM • x - F ……………………….(i)

or
π = P/V• x - F

π = CMR• S –F………………………………(ii)
(iii) Profit graph

When one plots the various costs and revenue graphs given the CVP assumptions, the
following diagram can be derived:

TR TC

Costs &
Revenues
Fixed TVC
Costs

Total
Costs

Variable
FC costs

Profit

0
X
Quantity
(Units)

-FC

Where: TC = Total Cost (Variable + Fixed costs)

Graphical Illustration between Cost and Revenue Behavior

CVP analysis in conditions subject to change

TVC = Total Variable cost
TR = Total revenue
FC = Fixed costs
X is the break-even point ( no loss and no profit)

Change in Selling Price and/or variable cost per Unit

The contribution sales ratio is affected by any change in selling price and or variable cost per
unit. This ratio is a measure of the rate at which profit is being earned and its size illustrated by
the steepness of the slope of the profit volume graph

Profit P1

P2

P3

0
Output, x
M3
M2
M1
-F
B1 B2 B3 S

To illustrate change in selling price and/ or contribution

In the figure above graph -FP2 shows the existing profit curve for a company with a fixed cost
OF, Break-even point B2, margin of safety M2. An increase in the selling price and/or decrease in
the variable cost per unit will increase the contribution margin ratio. This translates to a higher
profit. The graph line derived shall be steeper than the original one. In our chart above, the profit

Margin of safety (MOS)

line -FP1 illustrates such a situation.

A decrease in selling price and/or an increase in variable cost per unit will reduce contribution
margin ratio thus translating to a lower profit. The profit graph obtained shall be gentler than the
initial one. In the chart above, the profit line -FP3 illustrates such situation.
This is the excess of budgeted sales over the break-even volume in sales. It states the extent to
which sales can drop before losses begin to be incurred in a firm.

MOS is calculates as:

 MOS = Total budgeted sales – Break-even sales

MOS may also be expressed as a percentage of sales. The higher the percentage, the better
positioned a firm is in its operations.

MOS% = (MOS in Shillings/Total Sales) x 100%

Margin of safety is a tool designed to point out a problem but not to solve it. To rectify the problem
of a low MOS, management must direct its efforts towards either reducing the break-even point
or increasing the overall level of sales.
In the chart above, the margin of safety in the three situations analyzed equals M 2, M 1 and M 3
respectively

Change in fixed cost

Profit F3 P1
&
Costs
P2
F2

F1 P3

0
Output, x
M3
-F1 M2
M
-F2
B1 B2 B3 S

-F3

To illustrate effect of change in fixed costs

In figure on the previous page graph -F2P2 shows the existing profit curve for a company with a
fixed cost 0F2, Break-even point B2, margin of safety M2. Assuming constant production and
sales volume, an increase in the fixed costs (F3 -F2) will translate to an increase in the break-even
point (B3 -B2), a decrease in the Margin of safety (M2 –M3) and a decrease in profits. The profit
graph line will have the same gradient as the initial one since a change in fixed costs does not
affect the contribution to sales ratio. The line will shift downwards by a vertical distance
equivalent to the increase in the fixed costs (F3 -F2)

The profit line – F3P3 illustrates the situation above.

On the other hand, a decrease in the fixed costs (F2 –F1) will translate to a decrease in the
breakeven point; (B2 –B1), an increase in the margin of safety (M1 –M2) and an increase in the
profits. The profit graph line will have the same gradient as the initial one. The line will shift
downwards by a vertical distance equivalent to the decrease in the fixed costs (F2 –F1). The profit
line – F1P1 best illustrates the situation.

Change in production or sales mix

Determining the constituents of the sales Mix

>>> Illustration
One of the key assumptions of break-even analysis is that there is only one product or service or
a constant Sales Mix. Sales mix refers to the relative combination in which a company‟s products
are sold. Managers strive to achieve an optimal sales mix which yields the greatest amounts of
profits. Profits will be greater if high margin items make up a relative large proportion of sales
and less if sales consist of low margin items.

T-Bug plc produces and sells 2 products T and B. The following is the budget for the coming
year.

T B Total
Sales Units 120,000 40,000 160,000
Selling price per unit Shs.4 Shs.7.5
Sales 480,000 300,000 780,000
Variable cost Per Unit Shs.2 Shs.4
Total variable cost 240,000 160,000 400,000
Contribution margin 240,000 140,000 380,000
Fixed costs
Net income
Required:
 a) Compute the company‟s break-even point
b) Determine the constituents of the sales mix i.e. quantities of T and B
Solution
Sales Mix T B
Units Ratio 120,000 40,000
3 : 1
Let b be the number of units of B sold and 3b be the number of units of T sold.

Using the fundamental marginal cost equation

( Sales – variable cost) – fixed costs = Profit

Contribution – Fixed costs = Profit

But at break-even point, profit is equal to zero. Therefore,

Contribution – Fixed costs = 0 Contribution = Fixed costs

Given;
Sales = (Shs.4 x 3b) + (Shs.7.5 x b )

= Shs.12b + Shs.7.5b

= Shs.19.5 b

Variable costs = (Shs.2 x 3b) + (Shs.4 x b)

= Shs.6b + Shs.4b

= Shs.10b

Fixed costs = Shs. 250,000

Contribution = sales – variable costs

= Shs.19.50b – Shs.10b

= Shs.9.50b
Contribution = Fixed costs
Shs.9.50b = Shs.250,000

b = Shs.250,000

Shs.9.50

= 26,315.78 units

b = 26,316 is the number of units of B sold and 3 b = 78,948 is

the number of units of t sold Therefore the break-even point of T-Bug plc is
105,264 units comprising of 78,948 units of T and 26 ,316 units of B.

A change in sales mix without a change in the total output will no doubt give different results.
This is because the individual products in the mix have different contributions thus giving a

>>> Illustration
different weighted contribution sales ratio. This will cause a change in the overall profit curve.

The summary of results of Donlon Ltd are as follows;

Product A B C Total
Shs‟000 Shs‟000 Shs‟000 Shs‟000
Sales revenue 300 200 100 600
Variable costs 150 120 70 340
Contribution 260
Fixed costs 100
Net Profit 160
Contribution sales ratio 0.5 0.6 0.7 0.433
Required:
1. Prepare a profit volume graph which shows the overall results for Donlon Ltd

2. Prepare an amended profit curve where the market forces have led to a switch of
Shs.200,000 of sales from product A to Product C.
 3. Prepare a summary which shows the value of each of the following for both the original
results and the amended results.

 Net profit
 Break-even point
 Margin of safety
 Overall contribution sales ratio
Solution:

Profit
Amended

Initial graph

Sales Shs,000

100

The above profit volume graph shows the existing and amended cost curves for Donlon

The above profit volume graph shows the existing and amended cost curves for Donlon Ltd. The
amended data which shows the switch of Shs.200,000 of sales from product A to Product C may
be summarized as follows:

Product A B C Total
Shs‟000 Shs‟000 Shs‟000 Shs‟000
Sales revenue 100 200 300 600
Variable costs 50 120 210 380
Contribution 50 80 90 220
Fixed costs 100
Net Profit 120
Contribution sales ratio 0.5 0.4 0.3 0.367
Note that the variable costs for Product A are reduced proportionally while those of product C
are increased proportionally to the change in sales value according to the variable cost sales ratio
( VCR) for each product.

BREAK-EVEN POINT AND ANALYSIS

Break-even analysis and CVP analysis are one and the same thing. The only distinction is that
CVP analysis targets to establish the relationship between the volume of output, the cost incurred
and revenue received while Break-even analysis aims at establishing the minimum output that a
firm must produce and sell in order to remain in business. If a firm operates below that level of
activity, it makes a loss. Break-even analysis is built on CVP analysis principles.

Break-even point is the volume of sales where there is neither profit nor loss. At this point
revenues and total costs are equal. For every unit sold in excess of the break-even point, profit
will increase by the amount of the contribution per unit. All the variable costs and fixed costs are
covered by the sales revenue.

At Break-even point, BEP,

Total revenue = Total costs
Profit P = 0

Contribution = Fixed cost

Break-even analysis

Mathematical determination of Break-even point

Contribution – Fixed costs = 0

From the definition of break-even point, one can say that:

At Break-even point, Total revenue = Total costs and therefore, profit is equal to zero. i.e. from
the fundamental marginal equation, CM⋅x = F + Π, one can conclude that
Contribution (CM⋅x) – Fixed costs, F = 0, since Profit is equal to zero. Upon making
contribution the subject of the formula, one derives the following:

Contribution (CM⋅x) = Fixed cost (F )

CM⋅x = F

To obtain break-even point in units, make x (output) the subject of the formula by dividing both
sides of the equation by Contribution margin per unit.
Sale, Xbep = Fixed Costs
CMor(P-V)

Note that this formula is identical to the CVP one except for the profit, which in this case is zero.
This brings out clearly the idea that break-even analysis and cost volume profit analysis are one
and the same thing. In fact, the terms are at times used interchangeably.
To obtain break-even sales in shillings where one is dealing with a single item, multiply the
breakeven sales volume by the sales price. Alternatively, use the contribution margin ratio to
compute the same.

Using the equation below, one can calculate break-even sales in Shillings as follows:

π= CMR• S - F
π=0

therefore 0 = CMR• S – F
CMR •S = F
To obtain break-even point in sales, divide both sides of the equation by CMR

F
Sales (Shs), S bep =
CMR

Using the graphical approach

Break-even charts graphically display the relationship of cost to volume and profits and show
profit or loss at any sales volume within a relevant range. This is shown in the graph below.
(Assumption; fixed costs do not change )

TR
TC
Costs &
Rev enues

BEP
(Sales)

Profit

Quantity
BEP (Units)
(Units)

To illustrate the Break-even Point

>>> Illustration (Break-even and CVP analysis )
ABC produces and sells Product X at Shs.500. The Unit manufacturing cost of X is Shs.200 and
total fixed manufacturing costs equal to Shs.300,000. The company incurs selling and
administration costs equal to 2% of sales revenue and fixed selling cost of Shs.100,000 per
annum.

Required:
a) Determine the break-even sales in units and in shillings
b) Determine the units that should be sold to earn a net income of Shs.200,000
c) If the company was in the 30% tax bracket, how many units will have to be produced to
earn the Shs.200,000
d) Management is considering a policy which would increase fixed manufacturing costs
by shs.200,000 but cut down on the variable manufacturing cost by 20%
(i). What is the break-even point in units and in revenue under this policy?
(ii). Assuming the 30% tax bracket, how many units will have to be produced to earn the
target profit of Shs.200,000 under this new policy?
e) At what level of sales level will management be indifferent between the two policies?
f) Assuming that the maximum possible demand is 6,000 units, determine the range of
sales which will be financially beneficial in each policy.

Solution

Let the number of units produced be x

Shs
Summary of costs Variable manufacturing Costs per Unit 200
Variable Selling Costs (2% x Shs.200) __4
Variable costs per Unit 204

Fixed manufacturing costs 300,000

Fixed selling costs 100,000
Total fixed costs 400,000

(a) At break-even point profit is equal to zero; Sales (units) = fixed costs
i.e. Shs. (500 - 204) x - 400,000 = 0 CM
296 x -400,000 = 0 296 x = 400,000 = 400,000
(500 - 204)
= 1,351 units
 x = 400,000 / 296

x = 1,351

Sales (units) = fixed costs

CMR
Break-even point in sales is equal to = 400,000
Break-even ouput x selling price (500 - 204)
= 1,351 units x Shs.500 per unit 500

= Shs.675,500 = 1,351 units

(b) To earn a net income of Shs.200,000 Sales (units) = fixed costs +

Profit
Profit = Contribution - fixed costs CM
200,000 = (500 - 204) x - 400,000 = 360,000 +
296x = 600,000 200,000
x = 600,000/ 296 (500 - 204)
x = 2,027 units
= 2,027 units
Units to be sold shall be 2,027

(c) In the 30% bracket, the number of units to be sold to earn the targeted income shall be

Profit = Contribution - fixed costs

Gross up the amount of target profit in order to obtain the actual amount targeted before
tax i.e. the desired amount of profits shall be
70% of the total amount of profits earned, P Profit
i.e. 0.7 P = 200,000 Sales (units) = fixed costs + (1 -T
CMR
P = 200,000
0.7 = 400,000 + ( 200,000
1 - 0.3
= Shs.285,714
(500 - 204)
= 2,317 Units
 Using the marginal cost equation
285,714 = 296 x - 400,000
296 x = Shs.685,714
x = 685,714
296
= 2,317 Units

(d) With the new policy the new costs shall be

Variable manufacturing Costs per Unit (0.8 x 200) 160.00
Variable Selling Costs (2% x Shs.160) __3.20
Variable costs per Unit 163.20

Fixed manufacturing costs 500,000

Fixed selling costs 100,000
Total fixed costs 600,000

At break-even point profit is equal to zero; Sales (units) = fixed costs

i.e. Shs(500 - 163.2) x - 600,000 = 0 CM
336.8 x -600,000 = 0 336.8 x = 600,000
x = 600,000 = 600,000
(500 - 163.2)
336.8
= 1,781 Units
x = 1,781 Units
Break-even point in sales is equal to
Sales (units) = fixed costs
Break-even ouput x selling price CMR
= 1,781 units x Shs.500 per unit = 600,000
= Shs.890,500 (500 - 163.2)
500
= Shs. 890,500

In the 30% bracket, the number of units to be sold to earn the targeted income shall be:

Profit = Contribution - fixed costs

Gross up the amount of target profit in order to obtain the actual amount targeted before
tax
i.e. the desired amount of profits shall be 70% of the total amount of profits earned, P
i.e. 0.7 P = 200,000
P = 200,000/ 0.7
= Shs.285,714
Sales (units) = fixed costs + ( Profit
1-T
CMR

= 600,000 + ( 200,000
1 - 0.3

(500 - 163.2)
= 2,630 Units
 Using the marginal cost equation
285,714 = 336.8 x - 600,000
336.8 x = Shs.885,714
x = 885,714/336.8
= 2,630 Units

(d) The management will be indifferent between the two alternatives when profits obtained
shall be equal i.e. point of equilibrium between the two policies.
i.e. 296 x - 400,000 = 336.8 x - 600,000
(336.8 - 296)x = (600,000 -400,000)
40.8 x = 200,000
x = 200,000/408
x = 4, 902 units

Test for 5,000 units Test for 4000 units

Situation 1
Profit = 296 (5000) - 400,000 Profit = 296 (4000) - 400,000
= 1,480,000 - 400,000 = 1,840,000 - 400,000
= 1,080,000 = 1,440,000

Situation 2
Profit = 336.8 (5000) -600,000 Profit = 336.8 (4000) - 600,000
= 1,684,000 - 600,000 = 1,347,200 - 400,000
= 1,084,000 = 947,200
Policy II is more profitable than Policy I between 2,630 units and 4,902 units while Policy I is
more profitable between 4,902 units and 6,000 units of output.
 CVP and computer applications

The wide availability of personal computers encourages more managers to apply cost volume
profit analysis. Computers can quickly make the computations for changes in the assumptions
identifying proposed projects e.g. computer spreadsheets allow managers to determine the most
profitable combination of selling process, variable and fixed cost volume. A manager enters into
the computer various numbers for price and cost in an equation based on CVP relationships to
yield target income for each combination. Because of a computer‟s speed and accuracy in
providing this information, the manager can select the most profitable actions.

DECISION MAKING
Decision-making may fall into any of the following categories

1. Short run operational decisions

2. Short run tactical decisions

3. Longer term strategic planning decisions

Short run operational decisions are made in relation to the achievement of short-term output
requirements. A decision may be made to work overtime in a department in order to have a job
completed in accordance with a scheduled delivery date to the customer. Such decisions are
aimed at ensuring that the current business plan is achieved Short run tactical decisions are
related to specific events which management wish to decide upon and which will change the
future operation of the business in some way. Its time horizon is short and it is usually within 12
months.

Longer term strategic planning is more concerned with the overall direction of the business plan.
It may have a time horizon of 5 to 10 years. For example should a decision be made to install a
fully automated production line to replace existing labour intensive machine process. These
decisions require consideration of factors such as;
• The level of market likely to be available in future

• An estimation of changing price levels

• The timing of cash flows in relation to the decision

• The degree of uncertainty estimated in relation to data used in the evaluation of the
situation
 • The strategy which competitors are likely to implement

• The cost of capital or target rate of return

The decision making cycle

Steps in decision-making cycle are:

a) Clearly define the objective, which is to be the focus of the decision. This is important
in order that the decision makers have a well-defined problem, which has to be solved
and not a vague idea which lacks clarity.

b) Consider the alternative strategies available to the satisfactory attainment of the

objective. This is important in order that the final decision agreed upon has taken
account of all relevant possibilities.

c) Gather relevant information in order to compare alternative strategies in quantifiable

terms. This may require considerable thought and effort in order to ensure that all
relevant data are obtained.

d) Consider the qualitative factors, which are likely to influence the decision. This is
important as an element in decision making. There may be non-quantifiable costs and
benefits, which lead to a final choice of strategy different from the highest quantifiable
return.

e) Compare the alternative strategies using both quantitative and qualitative data and then
make a final decision.

f) Re-evaluate your decision; determine if you are achieving the objectives and if not,
repeat the process.

Relevant costs and decision-making

The relevance of costs will depend upon the purpose for which they are being used. Relevance is
related to future decision.
The relevance of costs in decision-making is related to whether they are avoidable in relation to
the decision made or if they are unavoidable, in that they will remain irrespective of the decision
taken. Relevant costs in decision-making are, therefore, said to be incremental and future costs
relating to the decision to be made. Costs are incremental if they will result in a difference e.g.
avoidable costs result in reduced cots if they are avoided. Future costs are those costs that have

Limiting factors and decision making

not yet been incurred i.e. they are not sunk costs or committed costs. This is explained further in
this text.

Limiting factor may be defined as „any factor, which has a limiting effect on the activities of an
undertaking at a point in time over a specific period‟

The decision-making strategy, which management wish to pursue, may be constrained because
of shortage of manpower, machinery, material, money, markets or a combination of these. It may
also be affected by the availability of management expertise and methods improvement
capability.

In short term decision making where one or more factors will limit the strategy which may be
implemented, it is likely that profit maximization will be seen as a major decision making goal.
It should be noted, however, that in practice a number of goals will form part of the objective of
an organization. In addition to short term profits management may wish to consider a number of
longerterm goals, for example

• Consolidation of market share.

• Improving longer term productivity and profitability.

• Quality leadership.

• Employee and customer satisfaction.

• Social responsibility.

This balance between short and long term goals is likely to lead to decisions, which are profit
satisfying rather than profit maximizing resulting in the satisfactory profit level being earned in
the shortterm
 Single Limiting factor

Where a single limiting factor exists, the decision making sequence may be implemented as
follows:
• Calculate the contribution per unit of limiting factor for each product.
• Rank the products in order of size and contribution per unit of limiting factor.

• Allow any minimum retention of less profitable products which is decided upon.

• Use up the total units of the limiting factor in order to fulfill the forecast quantities in
order of product ranking.

A company manufacturers and sells three products A, B & C. The unit cost and revenue structure
for each product and its maximum forecast demand for the coming period are as follows:-

Product A B C
Selling price per unit (Shs) 140 100 120
Variable cost per unit (Shs) 70 60 80
Maximum demand (Units) 500 300 300
Machine hours requested per unit 10 4 5
The company has a maximum of 6000 machine hours available during the coming period.
Annual fixed costs incurred amount to Sh20,000.

Required
(i) Calculate the number of units of each product A, B, and C, which should be produced
and sold in order to maximize profit

(ii) Calculate the maximum profit earned from the decision strategy per (i) above.

(iii) Suggest other factors which management may wish to consider which could result in a
change in their decision

(iv) Calculate the product units to be produced and sold and the net profit earned if the
company wishes to maximize sales of product A because it is thought to be a future
market leader

(v) Calculate the product units to be sold and the net profit earned it the company agree to
produce a minimum of 70% of the maximum demand of each product in order to
maintain market spread.
Solution
Product A B C Total
Maximum demand (Units) 500 300 300
Machine hours requested per unit 10 4 5
Machine hours required 5000 1200 1500 7700
Machine hours available
Short fall
The above calculation confirms that machine time is a limiting factor, which will restrict the
number of products, which can be produced and sold.
*** the figure is the balance of machine hours remaining after allocacting to other products in
order of ranking.

iii. The profit maximizing mix may not be implemented where management wish to
maintain a more balanced market mix or where they wish to concentrate on a future
market leader. In addition they may wish to explore the possibility of sub-contracting
some production or of acquiring additional machinery either on hire or part of a long
term expansion of capacity

iv. Where the sales of product A are to be maximized because it is thought that it will be a
future market leader, the analysis sequence is:

• Utilize the machine hours required to maximize production of A

i.e 500 units x 10 hrs = 5000 hrs

• Use the remaining 1000 machine hours to produce B and C in their ranking order.

Product B has a higher contribution per machine hour. The 1000 machine hours available
are sufficient to produce 1000/4 = 250 units of B. This is less than its maximum
demand. There are no hours left in which to produce product C.

The sales and profit strategy is therefore:

 Contribution
Units Total
per unit (Shs)
Product A 500 70 35000
Product B 280 40 10000
Product C Nil ____0
45000
Less fixed costs (20000)
Net profit 25000
v. Where sales have to be spread in order to satisfy 70% of the maximum demand of each
product as the first criterion, the analysis sequence is

• Utilize the machine hours required to produce 70% of the maximum production of
each product

• Use the residual hours up to the maximum of 6000 hours to produce additional
units of the product in their ranking up to the maximum demand in each case so
far as it is possible

Product A B C Total
Maximum demand (Units) 500 300 300
70% of the units 350 210 210
Machine hours utilised 3500 840 1050 5390
Balance to meet maximum demand 150 90 90
Ranking (as earlier calculated) 3 1 2
Residual hours usage Nil 360 250 610
Machine hours used 3500 1200 1300 6000
Total Units 350 300 260
Total contribution (Shs) 24500 12000 10400 46900
Less fixed costs (20000)
Net profit 26900

Direct cost as a relevant cost

Direct costs may be directly chargeable to a product or a cost center. They may be fixed costs or

>>> Illustration
variable costs when it comes to decision-making.

A summary of profit and loss reported in each of the three product lines B, C and D is as follows:

Product B C D
Shs‟000 Shs‟000 Shs‟000
Sales revenue 60 40 40
Less variable costs 40 30

Contribution 20 10 Less fixed costs 15 12 Net

profit _5 (2)

Required:
(i) Comment on the financial situation as required in the above summary
(ii) Comment on a decision to discontinue product C where

a. 60% of the fixed costs charged to it relate to advertising of product C and are avoidable
if discontinued.
b. All the fixed costs charged to product C are avoidable if discontinued

(iii) Discuss whether product D should be discontinued if

a. 90 % of fixed costs charged to it are company costs arbitrarily apportioned to it OR

b. Eliminating of its variable costs would result to an increase in the material costs for
products B and C because of lost discounts which would have an effect of increasing
their variable costs by 5% OR

c. Products B and D are complementary products whose sales demand is directly related
to that of each other.

Solution
The existing figures show that products Band C are making a contribution towards fixed costs
whereas product D is in a negative contribution situation. The cash out flow directly related to
product D are not paid for by the cash in flows from sales revenue. Product B shows a net profit
of Shs.5000 whereas product C shows a net loss of 2000. The question data has not indicated
whether the fixed costs allocated to each product are an arbitrary apportionment of the total
company fixed cost

Where 60% of the fixed costs charged to product C relate to advertising of the product and are
avoidable if it is discontinued, it is earning a net contribution or net margin of Shs. 10000 - (60%
x Shs. 12000) = Shs. 2800. This means that Product C is contributing to the net cash in flows of
the company and should be retained in the short term if no more profitable use of the capacity if
available

Where all the fixed costs charged to product C are avoidable if it is discontinued, this means that
they are directly attributable to product C. The net loss of Shs. 2000 is a true measure of its
effects on company cash flows. If the position cannot be improved, the company will save Shs.
2000 in the short term by discontinuing product C

Product D has a negative contribution of Shs. 2000, if 10% of the fixed costs charged to it are
directly attributable to the product. This adds a further Shs. 1000 (10% x 10000) to its adverse
effect on company cash flow

b) The variable costs of products B and C would increase by 5% if product D is

discontinued Increase in cost of products B and C = 5% x Shs.40000+ Shs. 30000) =
Shs. 3500
Savings by discontinuing product D = Shs. 2000
Net benefit of retaining product D = Shs. 1500
In this situation the discontinuance of product D will result in net loss to the company of
Shs. 1500 because of the increased costs of products B and C due to loss of discount
c) If products B and D are complementary products, their position must be examined. If
product D is discontinued it implies that product B sales will be lost. Product B
currently earns a contribution of Shs. 20000, which far outweighs the negative
contribution of Shs.2000, which results from product D. Both products should be
produced and sold

Incremental costs as relevant costs

An incremental cost is specifically incurred by the following a course of action and avoidable if
such action is not implemented. This contrasts with sunk costs, which have already been incurred
and cannot be avoided whether the future course of action is taken or not. Incremental costs are
relevant in decision-making situations such as:

a) Whether to buy in a component or service or manufacture it using the company‟s own

resources

b) Whether to further process one of the joint products which emerge from a process

>>> Example 3
before it is sold or sell it in its existing form without further processing.

A company currently makes a component which has the following unit cost structure

Direct materials Shs.100

Direct wages Shs.200
Variable Overheads Shs.50
Fixed overheads Shs.140
Total Shs.490
Required:
Advise the management whether the component should be bought in from outside the company
at Shs.330

Solution
1. The total cost to manufacture the component is Shs.490

2. The apparent saving by buying the component is Shs(490 - 330) = Shs.160

3. If the fixed overheads is an apportionment of the company‟s fixed overhead, which will
be avoided if production is discontinued, the relevant cost of manufacture is Shs.350.
This assumes that direct materials, direct labor and variable overheads are all directly
variable with the production of the component. This still leaves the purchase of the
component for Shs.330 a cheaper option than manufacture at a relevant cost of Shs.350.
4. Other factors which are non quantifiable in the short term should be considered,
however, before a final decision is made.
 a. Will the quality of the bought in component be as acceptable as that which is
manufactured internally?

b. Will the outside supplier be able to supply the components as required or will there be
production delays because of late delivery?

c. Will there be industrial relations problem because of the loss of jobs by workers who
currently make the component?

5. Further analysis of the solution may reveal that the production capacity currently used

Opportunity costs are relevant costs

to make the component could be used as an alternative manufacturing opportunity
which could be sold externally and yield a contribution equivalent of Shs. 50 for each
component it replaces

Opportunity cost introduces an additional concept which is not available as part of normal cost
analysis in the accounting record system

Opportunity cost may be defined as „the best opportunity foregone by following a particular
course of action‟, it may be redefined as the net cash flow lost by choosing one alternative rather
than another (value of the next best forgone alternative). Opportunity cost may be used in a
number of decision making situations where there is an alternative choice between possible
future course of action, Examples are:

a) Whether to close a department immediately or in one year time

b) Whether to operate an internal service department or to use an outside service.

c) Whether to accept one or another of two mutually exclusive contracts

Opportunity costs will be part of an incremental cost and revenue analysis in many decision
making situations