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CVP Analysis 3

CVP analysis is used to analyze how costs and profits change with different levels of activity. It assumes costs are either fixed or variable. Contribution is calculated as sales revenue minus variable costs, and profit is contribution minus fixed costs. The break-even point is the sales volume where total contribution equals total fixed costs, resulting in zero profit. CVP analysis can calculate break-even points in either units or rupees, and can also calculate the sales volume needed to achieve a target profit level.

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tahir abbas
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34 views

CVP Analysis 3

CVP analysis is used to analyze how costs and profits change with different levels of activity. It assumes costs are either fixed or variable. Contribution is calculated as sales revenue minus variable costs, and profit is contribution minus fixed costs. The break-even point is the sales volume where total contribution equals total fixed costs, resulting in zero profit. CVP analysis can calculate break-even points in either units or rupees, and can also calculate the sales volume needed to achieve a target profit level.

Uploaded by

tahir abbas
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Introduction to CVP analysis

CVP analysis stands for cost-volume-profit analysis. It is used to show how costs and profits change with
changes in the volume of activity. CVP analysis is an application of marginal costing concepts.

Assumptions in CVP analysis


 Costs are either fixed or variable. The variable cost per unit is the same at all levels of activity
(output and sales). Total fixed costs are a constant amount in each period.
 Fixed costs are normally assumed to remain unchanged at all levels of output.
 The contribution per unit is constant for each unit sold (of the same product).
 The sales price per unit is constant for every unit of product sold; therefore the contribution to
sales ratio is also a constant value at all levels of sales.
 If sales price per unit, variable cost per unit and fixed costs are not affected by volume of activity
sales and profits are maximised by maximising total contribution.

Contribution
Contribution is a key concept. Contribution is measured as sales revenue less variable costs.
Profit is measured as contribution minus fixed costs.
Illustration:
Rs.
Sales (Units sold × sales price per unit) X
Variable costs (Units sold × variable cost (X)
price per unit)
Contribution X
Fixed costs (X)
Profit X

Total contribution = Contribution per unit * Number of units sold.

Contribution per unit


It is assumed that contribution per unit (sales price minus variable cost) is a constant amount over all sales
volumes.

Example:

A company makes and sells a single product. The product has a variable production cost of Rs.8 per unit and a
variable selling cost of Rs.1per unit.

Total fixed costs (production, administration and sales and distribution fixed costs) are expected to be
Rs.500,000.

The selling price of the product is Rs.16.


The profit at sales volumes of 70,000, 80,000 and 90,000 units can be calculated as follows:

70,000 80,000 90,000


units units units
Rs. Rs. Rs.
Sales revenue 1,120,000 1,280,000 1,440,000
(Rs.16/unit)
Variable cost (630,000) (720,000) (810,000)
(Rs.9/unit)
Contribution 490,000 560,000 630,000
(Rs.7/unit)
Fixed costs (500,000) (500,000) (500,000)
Profit/(loss) (10,000) 60,000 130,000

Notes
A loss is incurred at 70,000 units of sales because total contribution is not large enough to cover fixed costs.
Profit increases as sales volume increases, and the increase in profit is due to the increase in total contribution
as sales volume increases.

Somewhere between 70,000 and 80,000 there is a number of units which if sold would result in neither a
profit nor a loss. This is known as the breakeven position.

Example:
Facts as before but calculating total contribution as the number of units * contribution per unit.

Contribution per unit


Rs.
Sales price per unit 16
Variable production cost per unit (8)
Variable selling cost per unit (1)
Contribution per unit 7

70,000 80,000 90,000


units units units
Rs. Rs. Rs.
70,000 * Rs. 7 per unit 490,000
80,000 * Rs. 7 per unit 560,000
90,000 * Rs. 7 per unit 630,000
Fixed costs (500,000) (500,000) (500,000)
Profit/(loss) (10,000) 60,000 130,000

Formula: CS ratio (contribution to sales ratio)


Contribution per unit
----------------------------
Selling price per unit
Example: C/S ratio

Contribution to sales ratio:


Contribution per unit/Selling price per unit = 7/16 = 0.4375

70,000 units 80,000 units 90,000 units


Rs. Rs. Rs.
Contribution 490,000 560,000 630,000
(Rs.7/unit)
CS ratio ÷0.4375 ÷0.4375 ÷0.4375
Sales revenue 1,120,000 1,280,000 1,440,000

Break-even analysis
CVP analysis can be used to calculate a break-even point for sales.

Break-even point is the volume of sales required in a period (such as the financial year) to ‘break even’
and make neither a profit nor a loss. At the break-even point, profit is 0.

Management might want to know what the break-even point is in order to:

 identify the minimum volume of sales that must be achieved in order to avoid a loss, or
 assess the amount of risk in the budget, by comparing the budgeted volume of sales with the
break-even volume.

Calculating the break-even point


The break-even point can be calculated using simple CVP analysis.

At the break-even point, the profit is Rs.0. If the profit is Rs.0, total contribution is exactly equal to
total fixed costs.

We therefore need to establish the volume of sales at which fixed costs and total contribution are the same
amount.

Two methods of calculating the break-even point


There are a number of methods of calculating the break-even point when the total fixed costs for the
period are known:

Method 1: Breakeven point expressed as a number of units.


The first method is to calculate the break-even point using the contribution per unit. This method can be
used where a company makes and sells just one product.

Formula: Breakeven point expressed as a number of units

Total fixed costs


Break-even point in sales units =
Contribution per unit
Once the breakeven point is calculated as a number of units it is easy to express it in terms of revenue by
multiplying the number of units by the selling price per item.

Example: Breakeven point as number of units

A company makes a single product that has a variable cost of sales of Rs.12 and a selling price of Rs.20
per unit. Budgeted fixed costs are Rs.600,000.

What volume of sales is required to break even?

Method 1 Break-even point in = Total fixed costs


sales units
Contribution per unit

Contribution per unit = Rs.20 – Rs.12 = Rs.8.

Therefore break-even point:


In units: Rs.600,000/Rs.8 per unit = 75,000 units of sales.
In sales revenue: 75,000 units × Rs.20 per unit = Rs.1,500,000 of sales.

Method 2: Breakeven point expressed in sales revenue


The second method calculates the break-even point in sales revenue.

Formula: Breakeven point expressed in sales revenue

Break-even point in revenue = Fixed costs


Contribution to sales ratio

Example: Breakeven point as revenue


A company makes a single product that has a variable cost of sales of Rs.12 and a selling price of Rs.20
per unit. Budgeted fixed costs are Rs.600,000.

What volume of sales is required to break even

Method 2

Break-even point in revenue = Total fixed costs


C/S ratio

C/S ratio = Rs.8/Rs.20 = 40%


Therefore break-even point:
In sales revenue = Rs.600,000/0.40 = Rs.1,500,000 in sales revenue.
In units = Rs.1,500,000 ÷ Rs.20 (sales price per unit) = 75,000 units.
Target profit

Management might want to know what the volume of sales must be in order to achieve a target profit.
CVP analysis can be used to calculate the volume of sales required.

The volume of sales required must be sufficient to earn a total contribution that covers the fixed costs and
makes the target amount of profit. In other words the contribution needed to earn the target profit is the
target profit plus the fixed costs.

The sales volume that is necessary to achieve this is calculated by dividing the target profit plus fixed
costs by the contribution per unit in the usual way.

Formula: Volume target expressed in units

Volume target (units) = Total fixed costs + target profit


Contribution per unit

Once the volume target is calculated as a number of units it is easy to express it in terms of revenue by
multiplying the number of units by the selling price per item.

Similarly the sales revenue that would achieve the target profit is calculated by dividing the target profit plus
fixed costs by the C/S ratio.

Formula: Volume target expressed in sales revenue

Volume target in revenue = Total fixed costs + target profit


Contribution to sales ratio

Example:

A company makes and sells a product that has a variable cost of Rs.5 per unit and sells for Rs.9 per unit.
Budgeted fixed costs are Rs.600,000 for the year, and the company wishes to make a profit of at least
Rs.100,000.

The sales volume required to achieve the target profit can be found as follows:

The total contribution must cover fixed costs and make the target profit.
Rs.
Fixed costs 600,000
Target profit 100,000
Total contribution required 700,000
Contribution per unit = Rs.9 – Rs.5 = Rs.4.

Sales volume required to make a profit of Rs.100,000:


Rs.700,000/Rs.4 per unit = 175,000 units.

Therefore the sales revenue required to achieve target profit


175,000 units × Rs.9 = Rs.1,575,000

Alternatively:
C/S ratio = 4/9
Sales revenue required to make a profit of Rs.100,000
= Rs.700,000 * (4/9) = Rs.1,575,000.
Therefore the number of units required to achieve target profit
Rs.1,575,000 ÷ Rs. 9 = 175,000 units

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