Session 07. Cost-Volume-Profit Analysis

Size: px

Start display at page:

Download "Session 07. Cost-Volume-Profit Analysis"

Gwendoline Harper
8 years ago
Views:

1 Session 07 Cost-Volume-Profit Analysis Programme : Executive Diploma in Business & Accounting (EDBA 2014) Course : Cost Analysis in Business Lecturer : Mr. Asanka Ranasinghe BBA (Finance), ACMA, CGMA Contact : asanka.ranasinghe11@yahoo.com

Course : Cost Analysis in Business Lecturer : Mr.

2 Cost-Volume-Profit Analysis The study of the effects on future profit of changes in fixed cost, variable cost, sales price, quantity and mix A common term used for this type of analysis is breakeven analysis. However, this is somewhat misleading, since it implies that the focus of the analysis is the breakeven point that is, the level of activity which produces neither profit nor loss but the scope of CVP analysis is much wider than this 2

However, this is somewhat misleading, since it implies that the focus of the analysis is the breakeven point

3 The concept of contribution Contribution = Sales value - Variable costs Breakeven Point As sales revenues grow from zero, the contribution also grows until it just covers the fixed costs. This is the breakeven point where neither profits nor losses are made. It follows that to break even the amount of contribution must exactly match the amount of fixed costs. If we know how much contribution is earned from each unit sold, then we can calculate the number of units required to break even as follows: 3

This is the breakeven point where neither profits nor losses are made.

4 Breakeven Point An organisation manufactures a single product, incurring variable costs of 30 per unit and fixed costs of 20,000 per month. If the product sells for 50 per unit, then the breakeven point 4

5 The Margin of Safety The margin of safety is the difference between the expected level of sales and the breakeven point The larger the margin of safety, the more likely it is that a profit will be made, that is, if sales start to fall there is more leeway before the organization begins to incur losses. In the above example, if forecast sales are 1,700 units per month, the margin of safety would be ; 5

made, that is, if sales start to fall there is more leeway before the organization begins to incur

6 The Margin of Safety The margin of safety can also be used as one route to a profit calculation. We have seen that the contribution goes towards fixed costs and profit. Once breakeven point is reached the fixed costs have been covered. After the breakeven point there are no more fixed costs to be covered and all of the contribution goes towards making profits grow. 6

Once breakeven point is reached the fixed costs have been covered.

7 Contribution to Sales (C/S) Ratio A higher contribution to sales ratio means that contribution grows more quickly as sales levels increase. Once the breakeven point has been passed, profits will accumulate more quickly than for a product with a lower contribution to sales ratio. Sometimes this ratio referred to as the profit volume (P/V) ratio. If we can assume that a unit s variable cost and selling price remain constant then the C/S ratio will also remain constant. It can be used to calculate the breakeven point as follows (using the data from the earlier example): 7

Sometimes this ratio referred to as the profit volume (P/V) ratio.

8 Contribution to Sales (C/S) Ratio 8

9 9

10 Contribution Breakeven Chart 10

11 The Profit-Volume Chart 11

12 Limitations of CVP Analysis Costs are assumed to behave in a linear fashion Sales revenues are assumed to be constant for each unit sold It is assumed that activity is the only factor affecting costs, and factors such as inflation are ignored Apart from the unrealistic situation of a constant product mix, the charts can only be applied to a single product or service The analysis seems to suggest that as long as the activity level is above the breakeven point, then a profit will be achieved 12

Apart from the unrealistic situation of a constant product mix, the charts can only be applied to a single product or

13 13

14 14

Chapter. Break-even analysis (CVP analysis)

Chapter. Break-even analysis (CVP analysis) Chapter 5 Break-even analysis (CVP analysis) 1 5.1 Introduction Cost-volume-profit (CVP) analysis looks at how profit changes when there are changes in variable costs, sales price, fixed costs and quantity.