CHAPTER ONE

COST-VOLUME-PROFIT RELATIONSHIP

Introduction

Cost-volume-profit analysis helps managers understand the relationship among cost,

volume and profits. Profits could be affected by selling prices, number of units sold, unit
variable costs, total fixed costs and mix of products sold. CVP analysis tries to
understand how profits are affected by these factors and helps managers make
decisions regarding the type of products and services to offer, how much price to
charge, what cost structure to follow and the like.

Managers need to estimate future revenues, costs, and profits to help them plan and
monitor operations. They use cost-volume-profit (CVP) analysis to identify the levels of
operating activity needed to avoid losses, achieve targeted profits, plan future
operations, and monitor organizational performance.

Cost-volume-profit (CVP) analysis is a technique that examines changes in profits in

response to changes in sales volumes, costs, and prices. Accountants often perform CVP
analysis to plan future levels of operating activity and provide information about:
_ Which products or services to emphasize
_ The volume of sales needed to achieve a targeted level of profit
_ The amount of revenue required to avoid losses
_ Whether to increase fixed costs
_ How much to budget for discretionary expenditures
_ Whether fixed costs expose the organization to an unacceptable level of risk

Assumptions of CVP analysis

1. Selling price is constant. The price of a product will not change as volume
changes.
2. Costs are linear and are divided into variable and fixed elements. The variable
element is constant per unit and the fixed component is constant in total over a
given relevant range.
3. In multiproduct companies, the sales mix is constant.

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4. In manufacturing companies, inventories do not change. The number of units

produced equals the number of units sold.

COST BEHAVIOR
Basically the cost of production has two behaviours:
1. Fixed Cost
2. Variable Cost

Fixed Cost
It is a cost which remains constant at various level of production It does not change
when there is increase or decrease in the various activity level.
Examples include:
a. Salary of the production manager (monthly/annual)
b. Insurance premium of factory work shop
c. Depreciation on straight line method

Variable Cost
A variable cost is a cost which changes at various level of production. It tends to vary
directly with the change in activity level. The variable cost per unit is the same amount
for each unit produced whereas total variable cost increases as volume of output
increases.
Examples include:
a. Cost of raw-material consumed
b. Direct labor cost
c. Selling commission

COST BEHAVIOR PER UNIT OF PRODUCTION

Cost per unit behaves differently than the total cost of production.

Following tables show the difference in behavior.

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Increasing Production Volume Situation

Per Unit Total

Fixed Cost Decrease Constant

Variable Cost Constant Increase

Total Cos Decrease Increase

Increase in production volume, decreases fixed cost per unit, whereas

Increase in production volume causes no change to the variable cost per unit as it
remains constant.

Following example helps understanding this concept.

Total fixed cost = 4,000 Birr
Per unit variable cost = 3 Birr
Units at different activity levels 1000, 2000, 4000, and 5000 units

1000 units 2000 units 4000 units 5000 units

Per Total Per Total Per Total Per Total
unit Unit Unit Unit
Birr Birr Birr Birr Birr Birr Birr Birr
Fixed cost 4 4000 2 4000 1 4000 0.8 4000
Variable cost 3 3000 3 6000 3 12000 3 15000
Total cost 7 7000 5 10000 4 16000 3.08 19000

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MARGINAL COSTING

Marginal costing is the same as variable cost. Marginal cost is the additional cost
of producing an additional unit of product. It is the total of all variable costs. It is
composed of all direct costs and variable overheads.

The CIMA London has defined marginal cost as the amount of any given volume
of output by which aggregate costs are changed, if volume of output is increased
or decreased by one unit.

Example

A Company manufactures 100 units of a product per month. Total fixed cist is
5000 Bir and marginal cost per unit is 250 Bir. The total cost per month will be

Marginal (variable ) cost of 100 units 25,000 Bir

Fixed cost 5,000 Bir

________

Total cost 30,000 Bir

________

If output is increased by one unit,the cost will appear as follows

Marginal cost (101*250) 25,250 Bir

Fixed cost 5,000 Bir

________

Total cost 30250 Bir

________

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Profit Equation and Contribution Margin

CVP analysis begins with the basic profit equation.
Profit = Total revenue - Total costs
Separating costs into variable and fixed categories, we express profit as:
Profit = Total revenue _ Total variable costs _ Total fixed costs

The contribution margin is total revenue minus total variable costs. Similarly, the
contribution margin per unit is the selling price per unit minus the variable cost per
unit. Both contribution margin and contribution margin per unit are valuable tools
when considering the effects of volume on profit. Contribution margin per unit tells us
how much revenue from each unit sold can be applied toward fixed costs. Once enough
units have been sold to cover all fixed costs, then the contribution margin per unit from
all remaining sales becomes profit.
If we assume that the selling price and variable cost per unit are constant, then total
revenue is equal to price times quantity, and total variable cost is variable cost per unit
times quantity. We then rewrite the profit equation in terms of the contribution margin
per unit

CONTRIBUTION

Contribution is the difference between sales and variable cost or marginal cost. It can
also be defined as the excess of selling price over variable cost per unit. Contribution is
also known as Contribution margin or gross margin.

Contribution is the excess of sales over variable cost is the amount that is contributed
towards fixed expenses and profit. Contribution can be represented as:

CONTRIBUTION = SALES VARIABLE COST

CONTRIBUTION= FIXED COST+ PROFIT

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CONTRIBUTION PER UNIT = SELLING PRICE PER UNIT- VARIABLE COST PER
UNIT

MARGINAL COST EQUATION

SALES VARIABLE COST = FIXED COST + PROFIT

SV= F+P

Contribution income statement

For the..
Total Per unit
Sales xxx xxx
Less Variable expenses xxx xxx
Contribution margin xxx xxx
Less Fixed expenses xxx
Profit xxx

PROFIT VOLUME RATIO (P/V RATIO)

The Profit Volume Ratio which is called the contribution ratio expresses the
relation of contribution to sales which can be expressed as follows

P/V RATIO = Contribution

Sales

= sales variable cost

Sales

= fixed cost + Profit

Sales

BREAK EVEN ANALYSIS

The study of cost volume profit analysis is often referred to as break even
analysis. Break even analysis is the most widely known form of cost volume profit

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analysis. In the broad sense , break even analysis refers to the study of
relationship between cost volume and profits. In the narrow sense, it refers to the
technique of determining the level of operations where total revenue equal total
expenses

Break even point

The volume of output of sales at which total cost is exactly equal to sales . i.e., the
point of no profit no loss.

BEP (in units) = Fixed cost

Contribution per unit

BEP(in sales) = Fixed cost

P/V ratio

Uses and Limitations of Break-Even Analysis:

In break-even analysis; the costs of an organization are compared with the level of sales
volume to find out the point at which the business likes non-profit no loss situation. It is
a useful tool for management to make various business decisions and deal with
uncertainty.

The uses of break-even analysis are as follows:

i. Helps in determining the sales volume

ii. Forecasts profits if estimates of revenue and cost are available

iii. Helps in appraising the effects of change on volume of sales and cost of production

iv. Assists in making choice of products and determining product mix

v. Highlights the impact of increase or decrease in the fixed and variable costs

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vi. Studies the effect of high-fixed costs and low variable costs

vii. Makes intra-firms profitability comparisons

viii. Helps planning of cash requirements for organizations effectively

limitations of break-even analysis are as follows:

i. Fails to be applied effectively in the multiple products situation

ii. Fails to be implemented in the situation where cost and price cannot be ascertained
and where historical data is not available

iii. Assumes fixed costs to be constant

iv. Assumes that quantity of goods produced is equal to the quantity of goods sold,
which may not be always true

v. Ignores changes in selling prices

vi. Ignores market conditions.

The margin of safety

The margin of safety is the excess of budgeted (actual sales) over the breakeven volume
of sales. It is the amount by which sales can drop before losses are incurred. The higher
the margin of safety, the lower the risk of not breaking even and incurring a loss. The
margin of safety is determined as:
Margin of safety in sales = total actual sales breakeven sales
Margin of safety in units = actual units sold - breakeven units
Margin of safety can also be expressed in terms of percentage
Margin of safety in percentage = Margin of safety in sales
Total actual sales

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LIMITATIONS OF COST VOLUME PROFIT ANALYSIS

1. It is presumed that the anticipatory capacity of production remain the same. But
it may be increased according to the need.
2. The analysis of cost volume profit remains satisfactory results only if elements
of cost remains stable. But in actual practice it varies.
3. It is presumed that plant capacity remains same. How ever the cost volume
relationship does not hold good if manual labour is replaced by machines.
4. In a business with many varities of products, it becomes difficult to forecast the
profits more accurately.