COST VOLUME PROFIT (CVP) CONCEPT

CVP is a systematic method of examining the relationship between changes in activity (i.e.
output) and changes in total sales revenue, expenses and net profit. As a model of these
relationships CVP analysis simplifies the real-world conditions that a firm will face. Like most
models, which are abstractions from reality, CVP analysis although being a powerful tool for
decision-making in certain situations it is subject to a number of underlying assumptions and
limitations.
This objective of CVP analysis is to establish what will happen to the financial results if a
specified level of activity or volume fluctuates. This information is vital to management, since
one of the most important variables influencing total sales revenue, total costs and profits is
output or volume. For this reason output is given special attention, since knowledge of this
relationship will enable management to identify the critical output levels, such as the level at
which neither a profit nor a loss will occur (i.e. the break-even point).

CVP analysis is based on the relationship between volume and sales revenue, costs and profit in
the short run, the short run normally being a period of one year, or less, in which the output of a
firm is restricted to that available from the current operating capacity. In the short run, some
inputs can be increased, but others cannot. For example, additional supplies of materials and
unskilled labour may be obtained at short notice, but it takes time to expand the capacity of plant
and machinery. Thus output is limited in the short run because plant facilities cannot be
expanded. It also takes time to reduce capacity, and therefore in the short run a firm must operate
on a relatively constant stock of production resources. Furthermore, most of the costs and prices
of a firm's products will have already been determined, and the major area of uncertainty will be
sales volume. Short-run profitability will therefore be most sensitive to sales volume. CVP
analysis thus' highlights the effects of changes in sales volume on the level of profits in the short
run.
1.1.1 Classification of costs in the short run
In the short run, costs can be of three general types:
 Fixed Cost.
Total fixed costs remain constant as volume varies in the relevant range of production. Fixed cost
per unit decreases as the cost is spread over an increasing number of units. Examples include:
Fire insurance, depreciation, facility rent, and property taxes.
 Variable Cost.
Variable cost per unit remains constant no matter how many units are made in the relevant range
of production. Total variable cost increases as the number of units increases. Examples include:
Production material and labor. If no units are made, neither cost is necessary or incurred.
However, each unit produced requires production material and labor.
 Semi variable Cost.
Semi variable costs include both fixed and variable cost elements. Costs may increase in steps or
increase relatively smoothly from a fixed base. Examples include: Supervision and utilities, such
 as electricity, gas, and telephone. Supervision costs tend to increase in steps as a supervisor's
span of control is reached. Utilities typically have a minimum service fee, with costs increasing
relatively smoothly as more of the utility is used.

1.2 APPLICATION AND CVP ASSUMPTIONS

1.2.1 Application of CVP

 Evaluating item price in price analysis.

Cost-volume-profit analysis assumes that total cost is composed of fixed and variable elements.
This assumption can be used to explain price changes as well as cost changes. As the volume
being acquired increases unit costs decline. As unit costs decline, the vendor can reduce prices
and same make the same profit per unit.
 Evaluating direct costs in pricing new contracts.
Quantity differences will often affect direct costs particularly direct material cost. Direct material
requirements often include a fixed component for development or production operation set-up.
As that direct cost is spread over an increasing volume unit costs should decline.
 Evaluating direct costs in pricing contract changes.
How will an increase in contract effort increase contract price? Some costs will increase others
will not. The concepts of cost-volume-profit analysis can be an invaluable aid in considering the
effect of the change on contract price.
 Evaluating indirect costs.
The principles of cost-volume-profit analysis can be used in indirect cost analysis. Many indirect
costs are fixed or semivariable. As overall volume increases, indirect cost rates typically decline
because fixed costs are spread over an increasing production volume.

1.2.2 The Main Assumptions required in C-V-P Analysis:

1. Revenues, costs and profit functions are assumed to be linear with respect to volume/level of
activity.
2. Cost can either be classified as either fixed/variable
3. Fixed cost shall remain constant within the activity range (the relevant range is used to refer to
the output range at which the firm expects to be operating within a short term planning horizon).
4. All units produced shall be sold i.e. no closing stocks
5. Price per unit, variable cost per unit shall remain constant
6. The only factor affecting revenue and costs is the volume of activity.
7. Level of technology/production methods shall remain constant.
8. Only one product /a constant mix of product or produced
9. There are no restrictions in form of contracts.
10. Efficiency and productivity remain the same so that we therefore ignore the learning curve
effect.
11. The relationship holds only within the relevant range. The relevant range is a band of activity
within which a given cost behaviour is defined.

1.1 BREAK EVEN ANALYSIS

Break even analysis is mainly used to explain the relationship between the cost incurred, the
volume operated at and the profit earned. To compute the break-even point we let
S = Selling price per unit
Vu = Variable cost per unit
Q = Break-even quantities
F = Total fixed costs
At Break-even point:
Total revenue (TR) = Total Cost (TC)
Total revenue will be given by SQ while Total cost (TC) = Vu Q + F
At break-even point (BEP) therefore:
SQ = Vu Q + F
Q = ___F___
S- Vu
B.E.P (in units) = F
S- Vu
1.1.1 Margin of Safety
The margin of safety is the amount by which actual output or sales may fall short of the budget
without the company incurring losses. It is a measure of the risk that the company might make a
loss if it fails to achieve the target. A high margin of safety means high profit expectation even if
the budget is not achieved. Margin of safety (MOS) can be computed as follows:

 Margin of Safety in Units Actual Units – Break Even Units

 Margin of Safety in Amount Actual Sales – Break Even Sales
 Margin of Safety in % = (Margin of Safety in units/sales ÷ Actual units/sales) x 100

Illustration III
Assume that you are planning to sell 600 Ice-creams at the forthcoming Nairobi Show at Sh.9
each. The Ice-creams cost Sh.5 to produce and you incur Sh. 2,000 to rent a booth in the Show
ground.
Required:
a) Compute the breakeven point
b) Compute the margin of safety %
 c) Compute the number of units that must be sold to earn a before tax profit of 20%
d) Compute the number of units that must be sold to earn an after tax profit of Sh.1640, assuming
that the tax rate is 30%.
Solution
a) Break-even point
B.E.P (in units) = F
S- Vu
BEP units = 2000/(9-5) = 500 units
BEP Sh. = 500 x 9 = 4500/-
b) Margin of safety
Margin of Safety in units = Actual Units – Break Even Units = 600 – 500 = 100
= 600 - 500 = 16.7%
600
c) Target before tax profit (Y)
Let X be the number of units to produce
X=F+Y
S - Vu
X = 2000 + 0.2 (9X)
9-5
X= 2000 + 1.8X
4
X = 909.09 Approximately 910 units.

d) After Tax profit

Let Z be the after tax profit
Y = Z__
I–t
Therefore
X = F + z/1-t
S – Vu
= 2000 + 1640
1-0.3 X = 1085.71 = approximately 1086 units.
9-5

1.2 C-V-P ANALYSIS – MULTIPLE PRODUCTS

The simple product CVP analysis can be extended to handle the more realistic situations where the
firm produces more than one product. The objective in such a case is to produce a mix that maximises
total contribution.
Total BEP units = Total fixed cost
Average CM
1.2.1 Contribution Margin
This is the amount of money that each unit disposes contributions towards the settlement of fixed cost.
It is the difference between the SELLING PRICE and VARIABLE COST

Contribution Margin; Selling Price (S.P) – Variable Cost (V.C)

n

 (S t  Vt ) t
Average CM = t 1

Where; αt = the sales mix of product t.

St = the selling price of product t.
Vt = the variable cost of product t.
n = the number of units of product t sold
BEPt units = αt (Total BEPunits)

BEP tsh. = BEPt(units) xSt

Illustration III
Assume that ABC Ltd produces two products, product A and B and the following budget has been
prepared.
A B Total
Sales in units 120,000 40,000 160,000
Sh. Sh. Sh.
Sales @5/-, 10/- 600,000 400,000 100,000
Variable cost @ 4/-, 3/- 480,000 120,000 600,000
Contribution @ 1/- 7/- 120,000 280,000 400,000
Total fixed cost 300,000
Profit 1,000,000

Required:
a) Compute the break-even point in total and for each of the products.
b) The company proposes to change the sales mix in units to 1:1 for products A and B.
Advice the Co. on whether this change is desirable.
Solution
A B
Sales mix (units) 0.75 0.25 1
Sales mix (Shs) 0.60 0.40 1
n

 (St  Vt )t
Average CM = t 1
= 0.75 (1) + 0.05(7)
= 2.5
Total BEP units = Total fixed cost = 300000
Average CM 2.5

= 120,000 units
BEP (units) BEP(sh)
A 120000 x 0.75 = 90,000 (90000x5) = 450,000
B 120000 x 0.25 = 30,000 (30000 x 10) = 300,000
120,000 750,000
The above question can be solved by computing the BEPSh first and the using the Sales Mix in Shs.
Total BEP Sh. = Total fixed cost
C/S sales ratio
C/S ratio = 400,000 = 0.4
1000,000
Total BEP(sh) = 300000 = 750,000
0.4
Sh. Units
A 750000 x 0.6 = 450000 450000/5 = 90000
B 750000 x 0.4 = 300000 300000/10= 30000
750000 120000
b) Changing sales mix in units to 1:1 ratio
The budget can be reproduced as follows:
A B Total
Sales in units 80000 80000 160000
sh sh sh
Sale @ 5/-, 10/- 400,000 800,000 1,200,000
V.c @ 4/-, 3/- 320,000 240,000 560,000
Contribution 80,000 560,000 640,000
Total fixed cost 300,000
Net Profit 340,000

Sales mix in units is 80,000/160,000 = 0.5

Average CM = 0.5(1) + 0.5 (7) = 4

Total BEP units = 300,000 = 75,000 units

4
BEP units BEP sh.
A (0.5 x 75000) 37500 187,500
B (0.5 x 75000) 37500 375,000
75000 562,500

For manager of product line A, the change is good because he now breaks even at sh. 187,500 than on
sh. 450,000. But for manager of product B, the change is not good because BEP has risen from sh.
300,000 to sh. 375,000.