Session 07 Cost-Volume-Profit Analysis 7.pdf · Cost-Volume-Profit Analysis • The study of the effects on future profit of changes in fixed cost, variable cost, sales price, quantity

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 : [email protected]

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:


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

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 ;

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.

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):

Contribution to Sales (C/S) Ratio



Contribution Breakeven Chart


The Profit-Volume Chart


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




Documents

Session 07 Cost-Volume-Profit Analysis 7.pdf · Cost-Volume-Profit Analysis • The study of the effects on future profit of changes in fixed cost, variable cost, sales price, quantity