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nirmal shrestha CVP Analysis and Limiting Factors

CHAPTER 3
CVP ANALYSIS AND LIMITING FACTORS

INTRODUCTION TO DECISION MAKING

The choice between two or more alternatives, decision making normally considers only the short- term
consideration of maximising profitability. We base our decisions on relevant costs and revenues.

CVP ANALYSIS (BREAKEVEN ANALYSIS)

What is CVP (break-even) analysis?

An understanding of 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).

It can also be used to predict the profits or losses to be earned at varying activity levels (using the assumed
linearity of costs and revenues).

CVP analysis assumes that selling prices and variable costs are constant per unit regardless of the level of
activity and that fixed costs are just that – fixed.

In order to calculate these levels we need to consider the contribution provided by each unit of production.
Contribution is the term given to the difference between the selling price and the variable costs which
contributes first towards paying the fixed costs and then towards providing profit.

Formulae required:
Unit contribution = Selling price per unit – Variable cost per unit
Total Contribution = Unit contribution x volume
CS Ratio = C/S
Break-even point (units) =

Break-even point ($) =

Contribution target = Fixed costs + Target profit

Sales to earn Desired Profit (Units) =

Sales to earn Desired Profit ($) =

/( )
Sales to earn Desired Profit after tax ($) =

Margin of Safety ($) = Sales – BEP level sales

Margin of Safety (%) = OR

Fixed Cost = BEP sales * CS Ratio

Profit = MOS Sales * CS Ratio

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We can use these formulae to calculate our break-even point. Alternatively, we can use either a traditional
break-even chart or a profit/volume chart.

Margin of safety
The margin of safety is the area between the break-even point and the maximum sales. This is the area that
the company can operate in and be certain of making a profit. It is usually classed as the amount of sales
that a company can afford to lose before it gets into a loss making situation.
It is usually expressed as a percentage (%) of sales.
It can be calculated as:
Margin of Safety (%) = OR

Note: Sales are alternatively described as budgeted sales revenues or Actual Sales revenues.
Contribution / sales ratio
The above calculations are useful in calculating the break-even point of one unit of production. If a company
makes more than one product it may be better to calculate the C/S ratio.

Break-even chart and Profit/volume chart

A break-even chart shows the costs and revenues at several activity levels. It does not however, show the
amount of profit or loss at these levels. This is shown on the profit/volume chart.
Illustration 1: Consider:
Selling price per unit $10
Variable cost per unit $6
Fixed cost $80
Draw table for sales level of 0,10, 20, 30, 40 and 50. Draw the break-even chart and profit volume chart.

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From this chart we can read off the amount of profit or loss for any level of activity.
1. The x axis represents sales (units or values)
2. The y axis shows profits above the x axis and losses below.
3. When sales = zero, the net loss is equal to the fixed costs.
4. If variable cost per unit and total fixed costs are constant throughout the relevant range, the
profit/volume chart is shown as a straight line.
5. If there are\changes in either of these costs at various levels of activity, it will be necessary to
calculate the profit or loss at each point where the cost structure alters before plotting the points onto
the chart.

Limitations of break-even analysis

 Once costs and revenues have been determined, it is usually assumed that they will have a linear
relationship.
 Fixed costs will be constant over the relevant range
 Variable costs will vary in direct proportion to volume
 Selling price will remain unchanged
 The efficiency and productivity of the workforce remain constant.

The analysis covers either a single product or a mix of products at which it is assumed that the proportion
of each product will remain the same as volume increases or decreases.
In constructing a break-even chart, the sales and costs are likely to be valid only in a particular range of
activity. This is referred to as THE RELEVANT RANGE. Outside this range the same cost and revenue
relationships are unlikely to exist. E.g. An alteration in volume could affect the level of fixed costs (stepped)
or the rate of variable costs or selling prices (economies of scale).

Practice Problems
1. A business manufactures a single product which it sells for $50. The variable costs of production are
$10 a unit. Next month fixed costs will be $800,000. The Finance Director wants to realise a profit of
$120,000. How many units must be sold to generate this profit? [Hints: 23,000 units]

2. A company makes a single product which it sells for $3 per unit. Fixed costs are $18,000 per month.
The contribution/sales ratio is 60%. Sales revenue is $43,500. What is the margin of safety in units?
[Hints: MOS 4,500 units or 31%]

3. A company maintains a margin of safety of 25% on its current sales and earns a profit of $ 30 million
per annum. If the company has a C/S Ratio of 40%, what is the current sales? Also, calculate fixed cost.
Hints: MOS = $75 million; Current sales = $ 300 million; FC = $90 million.

4. A company has annual turnover of $200 million and an average c/s ratio of 40%.It makes 10% of
profit on sales before charging depreciation and interest which amount to $10 million and $15 million
respectively. Find the annual fixed cost of the company. Hints: $ 85 million

5. Sales for two consecutive months of a company are $380,000 and $420,000. The company's net profits
for these two months amounted to $24,000 and $40,000 respectively. There is no change in C/S ratio or
fixed costs. Find the c/s ratio of the company. Hints: 40%

6. A company with a contribution / Sale ratio of 1 /3 and fixed cost of $3 million per month should have
a monthly sales of $ …………. million to maintain a margin of safety of 10%.
Hints: $10 million

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7. B Ltd. has earned net profit of $1 million, and its overall P/V ratio and margin of safety are 25% and
50% respectively, What is the total fixed cost of the company?
Hints: $1 million

8. A company produces single product which sells for $20 per unit. Variable cost is $ 15 per unit and
Fixed overhead for the year is $ 630,000.
Required:
(a) Calculate sales value needed to earn a profit of 10% on sales.
(b) Calculate sales price per unit to bring BEP down to 120,000 units.
(c) Calculate margin of safety sales if profit is $ 60,000.
Hints: (a) $4.2 million; (b) $20.25 ; (c) 25%

9. A company has fixed cost of $90,000, Sales $300,000 and Profit of $60,000.
Required:
(i) Sales volume if in the next period, the company suffered a loss of $30,000.
(ii) What is the margin of safety for a profit of $90,000?
Hints: (a) $120,000; (b) $180,000

Breakeven analysis in a multi-product environment

The breakeven point for a standard sales mix of products is calculated by dividing the total fixed costs
by the weighted average contribution per unit, or by the weighted average C/S ratio.

Weighted average C/S ratio

C/S ratio =
OR
Note: Weighted average C/S ratio is not the weighted average of C/S ratio of all the products.
Example 1: Alpha manufactures and sells three products, the Beta, the Gamma and the Delta. Relevant
information is as follows.
Beta Gamma Delta
$ per unit $ per unit $ per unit
Selling price 100 120 140
Variable cost 40 60 80
Total fixed costs are $1,800,000.
An analysis of past trading patterns indicates that the products Beta, Gamma and Delta are sold in the
ratio 4:6:5 respectively.
Required
Fill in the blanks in the sentence below.
Alpha's breakeven point in terms of revenue of the three products is .………..….............. of Beta,
…….…................ of Gamma and ……............…….... of Delta, making …..…..……....... in total.
Hints: BEP (Activity) = 30,000 units; BEP- Beta - $800,000 (8,000 units), Gamma – $1,440,000 (12,000
units); Delta $ 1,400,00 (10,000 units); Total $ 3,640,000.
Example 2: BA produces and sells two products. The W sells for $8 per unit and has a total variable cost
of $3.80 per unit, while the R sells for $14 per unit and has a total variable cost of $4.30. For every five
units of W sold, six units of R are sold. BA's expected fixed costs are $83,160 for the per period.
Budgeted sales revenue for next period is $150,040, in the standard sales mix.
Required
Calculate the margin of safety in terms of sales revenue and also as a percentage of budgeted sales
revenue.
Hints: Weighted Contribution per unit = $7.20; BEP activity = 11,550 (5,250, 6,300); MOS = 13.2%.

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Example 3: An organisation makes and sells three products, F, G and H. The products are sold in the
proportions F:G:H = 2:1:3. The organisation's fixed costs are $80,000 per month and details of the
products are as follows.
Selling price Variable cost
Product $ per unit $ per unit
F 22 16
G 15 12
H 19 13
The organization wishes to earn a profit of $52,000 next month. Calculate the required sales value of
each product in order to achieve this target profit.
Hints: BEP Activity = 24,000 units (8,000, 4,000, 12,000) $464,000

Multi-product P/V charts

Breakeven charts for multiple products can be drawn if a constant product sales mix is assumed.
The P/V chart can show information about each product individually.
A very serious limitation of breakeven charts is that they can show the costs, revenues, profits and
margins of safety for a single product only, or at best for a single 'sales mix' of products.
Example 4: A company sells three products, X, Y and Z. Cost and sales data for one period are as
follows.
X Y Z
Sales volume 2,000 units 2,000 units 5,000 units
Sales price per unit $3 $4 $2
Variable cost per unit $2.25 $3.50 $1.20
Total fixed costs $3,500
Required
Construct a multi-product P/V chart based on the above information.
Hints: Cumulative profit = Z - $500; Z&X -$2,000; ZX&Y = $3,000
PV Chart of Example 4:

The multi-product P/V chart therefore helps to identify the following.

(a) The overall company breakeven point
(b) Which products should be expanded in output and which, if any, should be discontinued

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(c) What effect changes in selling price and sales volume will have on the company's breakeven point and
profit
Example 5: Sutton produces four products. Relevant data is shown below for period 2.
Product M Product A Product R Product P
C/S ratio 5% 10% 15% 20%
Maximum sales value $200,000 $120,000 $200,000 $180,000
Minimum sales value $50,000 $50,000 $20,000 $10,000
The fixed costs for period 2 are budgeted at $60,000.
Required
Fill in the blank in the sentence below.
The lowest breakeven sales value, subject to meeting the minimum sales value constraints, is $........…..
Hints: Min. BEP Sales $130,000 (minimum sales) + $170,000 (from P) + $90,000 (from R) = $390,000

LIMITING FACTOR ANALYSIS

All companies have a maximum capacity for producing goods or providing services because there is a limit
to the number of resources available. There is always at least one resource that is more restrictive than
others: this is known as a limiting factor.
Limiting factor decision
Where there is a factor of production that is limited in some way by:
1. Scarce raw materials.
2. Shortage of skilled labour.
3. Limited machine capacity.
4. Finance (see capital rationing in FM).
Aim: Maximise the contribution per unit of limiting factor
Steps:
1. Contribution per unit of sale.
2. Contribution per unit of scarce resource.
3. Rank in order of 2 - highest first.
4. Use up the resource in order of the ranking.

Assumption:
 Fixed cost is assumed to be the same whatever the production mix is selected, so that the only
relevant cost is the variable cost.
 The unit variable cost is constant at all levels of production and sales
 The estimates of sales demand for each product are known with certainty
Example 6: Neal Ltd produces two products using the same machinery. The hours available on this
machine are limited to 5,100. Information regarding the two products is detailed below:
Products (per unit data) M N
Selling price (£) 40 30
Variable cost (£) 16 15
Fixed cost (£) 10 8
Profit (£) 14 7
Machine hours 8 3
Bud. sales (units) 600 500
Required:
Calculate the maximum profit that may be earned.
Hints: Total profit £8,300 (M -450 units and N – 500 units)

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Example 7: Using the previous example, Neal Ltd is now able to buy in the products at the following
costs
Products (per unit data) M N
Purchase price (£) 22 18
Required:
What is the revised production schedule and the maximum profit earned?
Hints: Revised Profit £10,700 (M- 600; N- 100 (400 purchase))
Limiting factor analysis − make or buy decisions and scarce resources
Example 8: WXYZ Ltd makes four products W, X, Y and Z for which costs and sales in the next year
are expected to be as follows:
W X Y Z
Sales units 2,000 4,000 3,000 1,000
£ £ £ £
Direct materials 10 5 7.5 12.5
Direct labour 7 2 4.5 6.5
17 7 12 19
Sales price 29 11 18 39
Contribution 12 4 6 20
The company is having difficulty of obtaining the materials. Each product uses the same material, and
only one type of material is used in manufacture. The expected available materials next year are 11,000
kilos. The material cost £5 per kilo.
An overseas manufacturer is willing to supply the items to the company at the following costs per unit
including delivery.
W X Y Z
Cost to buy 20.00 11.00 15.75 21.50
Required:
Which items should the company make internally, and which should it buy from the external
manufacturer?
Hints: Make: X = 4,000 Units; Y = 3,000 Units; W = 1,250 Units; Total Contribution = £49,000
Buy: W = 750 units ; Z = 1,000 units; Total Contribution = £73,250
Example 9: TW manufactures two products, the D and the E, using the same material for each. Annual
demand for the D is 9,000 units, while demand for the E is 12,000 units. The variable production cost
per unit of the D is $10, that of the E $15. The D requires 3.5 kg of raw material per unit, the E requires
8 kg of raw material per unit. Supply of raw material will be limited to 87,500 kg during the year.
A subcontractor has quoted prices of $17 per unit for the D and $25 per unit for the E to supply the
product. How many of each product should TW manufacture in order to maximise profits?
Required
Fill in the blanks in the sentence below.
TW should manufacture ........... units of D and .............. units of E to maximise profits.
Hints: D- 9,000 units and E- 7,000 units. (Variable cost of buying per kg $2 and $1.25)

LINEAR PROGRAMMING – MULTI LIMITING FACTORS

The aim of decision making is to maximise profit, assuming that the fixed cost does not change, this would
mean that we must maximise contribution. Alternatively, the aim may be to minimise cost to subsequently
maximise profit.
Linear programming involves the construction of a mathematical model to represent the decision problem
where the activities of the problem constitute variables.
Steps
1. Define the problem (unknowns or variables)
2. Objective function
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3. Constraints
4. Graph
5. Optimal solution
6. Shadow prices

Illustration 2: A company makes two products (X and Y), within three departments (A, B and C). Production
times per unit, contribution per unit and the hours available in each department are shown below:
Product X Product Y Capacity (hours)
Contribution/unit £4 £8
Hours/unit8 Hours/unit
Department A 8 10 11,000
Department B 4 10 9,000
Department C 12 6 12,000
There is unlimited demand for Product X, but demand for Product Y is limited to 600 units per annum.
Required:
a) What is the optimum production plan in order to maximise contribution?
b) Calculate the slack for the department C.
c) Calculate shadow price for binding constraints.
Solution:
1. Define the problem
Let x = number of units of X produced
Let y = number of units of Y produced

2. Objective Function – maximise contribution = Z

Z = 4x + 8y
3. Subject to – constraints
(Dept A hrs) 8x + 10y ≤ 11000
(Dept B hrs) 4x + 10y ≤ 9000
(Dept C hrs) 12x + 6y ≤ 12000
(non-negativity) x, y≥0
y ≤ 600
4. Plotting the graph
If we know the constraints, we are able to plot the limitations on a graph identifying feasible and non-
feasible regions. The linearity of the problem means that we need only identify two points on each constraint
boundary or line. The easiest to identify will be the intersections with the x and y-axes.
For example:
Dept A hrs – equating the formula 8x + 10y = 11,000
If x = 0 then y = 1,100 Co-ordinates (0, 1100)
If y = 0 then x = 1,375 (1375, 0)
And hence:
Dept B hrs – 4x + 10y = 9,000 (0, 900) (2250, 0)
Dept C hrs – 12x + 6y = 12,000 (0, 2000) (1000, 0)
For constraints of product Y – y = 600
By plotting the individual constraints, we build up an area of what is possible within all the constraints i.e.
the FEASIBLE REGION.

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Identifying the optimal solution

1. The Iso-contribution (IC line) line is plotted identifying points of equal contribution. The linear nature
of the problem means that this line will be a straight line identifying an inverse relationship between the
two products.
The IC line is of importance because the relationship of the contribution earned by each product is constant
(ie £4 for R against £8 for S). This means that the gradient of the line will remain constant as the total
contribution figure gets larger or smaller.
If we ‘push out’ the IC line to the point where it leaves the feasible region, that point will be the point of
maximum contribution.
Steps
(i) Choose an arbitrary contribution figure (preferably one that can be easily plotted on the graph just
drawn).
Example contribution = Z = £3,200
(ii) What are the objective function values?
4x + 8y = 3,200
(iii) Translate those values into co-ordinates for plotting on the graph
Co-ordinates (0, 400) and (800, 0)

2. The optimal solution can now be found by interrogating the point at which the IC line leaves the feasible
region to identify the co-ordinates and hence the product mix and maximum contribution.
The intersection or VERTEX identified is where two constraints meet, those constraints can be solved
simultaneously to identify the product mix.
8x + 10y = 11,000 ----------i
y = 600 -----------------------ii
Solving i & ii x = 625
y = 600
Therefore, the optimal product mix is to make and sell 625 units of X and 600 units of Y. The maximum
contribution is (625 x 4 + 600 x 8) = £7,300.
This can be checked by seeing how much of the constraints are used up:

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Dept hours used hours available

A 625 x 8 + 600 x 10 = 11,000 hours 11,000 hours
B 625 x 4 + 600 x 10 = 8,500 hours 9,000 hours
C 625 x 12+ 600 x 6 = 11,100 hours 12,000 hours
Department B and C has 500 and1,800 hours un-utilised respectively and is to be binding on the decision,
it is called a slack constraint.
Departments A is fully utilised or what are termed binding constraints (i. e. they bind the decision or output).

Slack and surplus

Slack occurs when maximum availability of a resource is not used: slack is the amount of the unused
resource or other constraint, where the constraint is a 'less than or equal to' constraint.

Surplus occurs when more than a minimum requirement is used: surplus is the excess over the minimum
amount of constraint, where the constraint is a 'more than or equal to' constraint. For example, there is
minimum requirement of production 30 units of M but optimal production required 40 units of M, it means
10 units surplus.

SENSITIVITY ANALYSIS – SHADOW PRICE

An investigation to identify how the optimum solution will change with changes to individual variables.
The SHADOW PRICE or dual price is the amount by which the total optimal contribution would rise if an
additional unit of input (hour) was made available.

Department A – shadow price of one hour

If one more hour was available (ie 11,001 hours now), the constraint of department A will relax outward
slightly which should improve the overall optimum solution. Solve the new constraint equations:
Dept A 8x + 10y = 11,001
y = 600
Revised solution:
x = 625.125; y = 600
Revised contribution:
625.125*4+600*8 = £7,300.50
Shadow price:
£7,300.50 - £7,300 = £0.5 per hour of dept A

Department B&C – shadow price of one hour

Department B&C already have spare capacity, extra hours would not increase the contribution generated
by the optimum solution (they would not change the solution). They have no shadow price.

Assumptions and limitations of linear programming

 Linear programming may be used when relationships are assumed to be linear and where an optimum
solution does in fact exist.
 Assumes contribution per unit for each product is constant irrespective of the total quantities produced
and sold
 Assumes utilisation of resource per unit for each product is constant irrespective of the total quantities
produced and sold
 Assumes that units produced, and resources allocated are infinitely divisible.
 When there are number of variables, it becomes too complex to solve manually and a computer is
required.

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Example 10: Cantata operates a small machine shop. Next month he plans to manufacture two products,
A and B upon which the unit contribution is estimated to be £50 and £70 respectively.
For their manufacture both products require inputs of machine processing time, raw materials, and
labour. Each unit of product A requires 3 hours of machine processing time, 16 units of raw materials
and 6 hours of labour. The corresponding per unit requirements for product B is 10, 4 and 6 respectively.
Cantata forecasts that next month he can make available 330 hours of machine processing time, 400 units
of raw materials and 240 labour hours. The technology of the manufacturing process is such that at least
12 units of product B must be made in any given time.
Required:
How many units of product A and B should be produced in order to maximize contribution?
Hints: 10 units of product A and 30 units of B; Total Contribution = £2,600
Example 11: Tronto is a family-operated business that manufactures fertilizers. One of its products is a
liquid plant feed into which certain additives are put to improve effectiveness. Every 10,000 liters of this
feed must contain at least 480g of additive A, 800g of additive B and 640g of additive C. Tronto can
purchase two ingredients (X and Y) that contain these three additives. The information, together with the
cost of each ingredient, is given as follows:
Ingredient X Ingredient Y
Additive A 2g 8g
Additive B 5g 10g
Additive C 10g 4g
Cost per litre £25 £50
Both ingredients require specialist storage facilities and as such no more than 120 liters each can be held
in stock at any one time.
Tronto’s objective is to determine how many liters of each ingredient should be added to every 10,000
litres of plant feed so as to minimize cost.
Hints: 40 litres of ingredient X and 60 litres of ingredient Y, or 80 liters of ingredient X and 40 litres of
ingredient Y; Cost = £4,000 for each.

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