COST-VOLUME-PROFIT (CVP)BREAK-EVEN ANALYSIS

Prepared by: Jessy ChongURL: chongsk818.blogspot.com

CVP AnalysisCVP (Cost-volume-profit) analysis is a term given to the study

of the interrelationships between the elements of costs and volume over the profit of the business.

CVP Analysis is an important short-term planning tool and useful for decision making – Marginal Costing Principle

Key Formulae:Units $

BEP Fixed cost / contribution per unit

Fixed costs / CS ratio

MOS Profit / Contribution per unit

Profit / CS ratio

Salesrequired

Fixed costs + Profit Contribution per unit

Fixed costs + Profit CS ratio

AssumptionsCVP analysis can apply to one product only, or to more

than one product only if they are sold in a fixed sales mix (fixed proportions).

Fixed costs per period are same in total, and unit variable costs are a constant amount at all levels of output and sales.

Sales price are constant at all levels of activity.Production volume = sales volume

Breakeven, Contribution and P/V Charts

Multiple Products CVPTo perform breakeven analysis for a multi-product organization, either

a constant sales mix must be assumed, or all products must have the same C/S ratio.

To 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.

Formulae:BEP(unit) = Fixed cost

Weighted average contribution per unit

BEP($) = Fixed cost Weighted average C/S ratio

Illustration: Hair Co (12/12)

Hair Co manufactures three types of electrical for hair: curlers (C), straightening irons (S) and dryers (D). The budgeted sales prices and volumes for the next year are as follows:

Each product is made using a different mix of the same materials and labour. The budgeted sales volumes for all the products have been calculated by adding 10% to last year’s sales.

The standard cost for each product is shown below.

Labour costs are variable. The general fixed overheads are expected to be $640,000 for the

next year.

C S D

Selling price $110 $160 $120

Units 20,000 22,000 26,000

C S D$ $ $

Materials 20 50 42Labour 30 54 50

Cont’dRequired:Calculate the weighted average contribution to sales ratio

for Hair Co. (4 marks)Calculate the total break-even sales revenue for the next

year for Hair Co. (2 marks)Draw a multi-product profit-volume (PV) chart showing

clearly the profit/loss line assuming: You are able to sell the products in order of the ones with the

highest ranking contribution to sales ratios first; and You sell the products in a constant mix. (9 marks)

Note: Round all workings to two decimal(15 marks)

LimitationsIt is assumed that fixed costs are the same in total and variable costs

are the same per unit at all levels of output. This is assumption is a great simplification.

Fixed costs will change if output falls or increases substantially (most fixed costs are step costs).

The variable cost per unit will decrease where economies of scale are made at higher output volumes, but the variable cost per unit will also eventually rise when diseconomies of scale begin to appear at even higher volumes of output (for example the extra cost of labour in overtime working).

Limitations (Cont’d)The assumption is only correct within a normal range or relevant range of

output. It is generally assumed that both the budgeted output and the breakeven point lie within this relevant range.

It is assumed that sales prices will be constant at all levels of activity. This may not be true, especially at higher volumes of output, where the price may have to be reduced to win the extra sales.

Production and sales are assumed to be the same, so that the consequences of any increase in inventory levels or of “de-stocking” are ignored.

Uncertainty in the estimates of fixed costs and unit variable costs is often ignores.

AdvantagesGraphical representation of cost and revenue data (breakeven

charts) can be more easily understood by non-financial managers.

A breakeven model enables profit or loss at any level of activity within the range for which the model is valid to be determined, and the C/S ratio can indicate the relative profitability of different products.

Highlighting the breakeven point and the margin of safety gives managers some indication of the level of risk involved.