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Session 07
Cost-Volume-Profit Analysis
Programme : Executive Diploma in Business & Accounting (EDBA 2015)
Course : Cost Analysis in Business
Lecturer : Mr. Asanka Ranasinghe
BBA (Finance), ACMA, CGMA
Contact : asanka.ranasinghe11@yahoo.com
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
Asanka Ranasinghe BBA (Finance), ACMA, CGMA2
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:
Asanka Ranasinghe BBA (Finance), ACMA, CGMA3
Breakeven Point
Asanka Ranasinghe BBA (Finance), ACMA, CGMA4
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
The Margin of Safety
Asanka Ranasinghe BBA (Finance), ACMA, CGMA5
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 ;
The Margin of Safety
Asanka Ranasinghe BBA (Finance), ACMA, CGMA6
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.
Contribution to Sales (C/S) Ratio
Asanka Ranasinghe BBA (Finance), ACMA, CGMA7
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):
Contribution to Sales (C/S) Ratio
Asanka Ranasinghe BBA (Finance), ACMA, CGMA8
Asanka Ranasinghe BBA (Finance), ACMA, CGMA9
Contribution Breakeven Chart
Asanka Ranasinghe BBA (Finance), ACMA, CGMA10
The Profit-Volume Chart
Asanka Ranasinghe BBA (Finance), ACMA, CGMA11
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
Asanka Ranasinghe BBA (Finance), ACMA, CGMA12
Asanka Ranasinghe BBA (Finance), ACMA, CGMA13
Asanka Ranasinghe BBA (Finance), ACMA, CGMA14
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