COST – VOLUME – PROFIT ANALYSIS

This is a systematic method of examining the relationship between changes in activity (output) and changes in
total sales revenue, expenses and net profit. M .A. can be of assistance in providing answers to questions
about consequences of the following particular courses of a solution. Such questions might include:
- How many units must we sell more units?
- What would be the effect on profit if we reduce our selling price and sell more units?
- What sales volume is required to meet additional fixed charges arising from an advertising campaign?
- These are other questions can be answered using CVP analysis.

The objective of CVP analysis is to establish what will happen to the financial results if a specified level of
activity or volume fluctuates. This is important information to management since one of the most important
variables influencing total sales revenue total costs, and profits in output. CVP analysis is based in relationship
between volume and sales revenue, costs and profits in the short run, the short run being a period of one
year, or less.

BREAKEVEN ANALYSIS
This is the term used to study the interrelationship between costs, volume and profit at various levels of
activity. The term breakeven analysis implies that the only concern is with that level of activity which
produces neither profit nor loss. The breakeven point which is misleading because the behavior of costs and
profits at other levels is usually of much greater significance because of this an alternatives term, cost volume-
profit analysis or CVP analysis, is frequently used and is more descriptive.
Concept of Relevant Range:
This is the range in which all assumptions about the level of activities and cost will remain
valid. Within this range, most items of cost will settle into a basic pattern or behaviour and cost can be classified into either fixed or
variable cost.

Illustration
Have you ever heard of installed capacity before this time? If you have, then think about a car
that has the capacity to carry just five persons or a machine that can work continuously for just
twelve hours., if you want the car to carry more than five persons, then you have to procure
another car to extend your relevant range, or if you want the machine to work continuously for
twenty-four hours, you may have to procure the second machine because that machine has
just twelve hours as its Stalled capacity.

CVP analysis Assumptions

Before any formulae are given or graph drawn, the major assumptions behind CVP analysis must be stated Its
essential that everyone preparing/interpreting CVP information is aware of the underlying assumption on
which the information is prepared. If these assumptions are not recognized, serious errors may result, and
increased conclusions may b drawn from the analysis.

The assumptions are:

1. All other variables remain constant expect volume through out the analysis.
2. Particularly for the graphical method, that the analysis relates to one product only.
3. Within the relevant range, Total Cost and Total Revenue are linear functions of output.
4. Analysis applies to relevant range only.
5. Costs can be accurately divided into their fixed and variable elements.
6. Fixed cost will remain constant at all levels within a given range.
7. The analysis applies only to a Short term. time horizon.
8. That technology, production methods and efficiency remain unchanged.
9. That the only factors affecting costs and revenues is volume.
It will be seen that these are over simplifying assumptions for many practical situations. It is because of this
that CVP analysis can only be an approximate guide for decision making. Never the less, by highlighting the
interaction of costs, be provided for managers making short run, tactical decision.

Uses of CVP chart

The CVP chart as a management tool has the following benefits (advantages).
i) This chart is helpful to find the breakeven point and profit or loss at a specific level of output.
ii) It shows the behavior trend of costs and sales.
iii) It establishes the relationship between costs, sales and profits. This information can be further used
to make the proper decision.
iv) It helps to find the safety level at a particular level of activity.

Limitations of BEF chart

- The chart shows cost, volume and profit relationship a simplified and approximation manner. They
can be useful aids, but whenever they are used the following limitations should be forgotten.
a) The chart is reasonable pointer to performance within normal activity ranges, e.g. between 70%-
120% of average production. Outside this relevant range, the relationship depicted almost certainly will not
be correct.
b) Fixed costs are likely to change at different activity levels. A stepped fixed cost line is probably the
most accurate representation.
c) Variable costs and sales are unlikely o be linear. Extra discounts, overtime payments, special delivery
changes etc. make it likely that variable cost and revenue lines are form of a curve rather than c straight line.
d) The chart depicts relationships which are essentially short term. This makes them inappropriate for
planning purposes where the time scale stretches over several years.

CVP analysis
CVP can be undertaken by:
i. Graphical means
The following steps are used:
1. The sales line
Plot the sales volume on the horizontal axis. Sale volume can be in terms of shillings
units, or as a percentage of capacity.

2. Cost and revenue lines

Revenues, variable costs and fixed cost are represented on the vertical axis.

3. Fixed cost line

They are down parallel to the horizontal axis.

Illustration
A company makes a single product with a capacity of 400,000litres per annum and sales data are as follows:
sales price of sh 100/ liter and a marginal cost of sh 50/ liter. Fixed is sh 10,000,000. Required: Draw a
traditional break even chart showing the likely profit at the expected production level of 300,000 liters.
ii. Formulae
The following formulae are used:
a) Breakeven point in sales =
b) Breakeven point in sales = x sales price/unit
= fixed costs x
c) ratio = x 100
 d) Level of sales to result in target profit (in units) =

e) Level of sales to result in target profit after tax (units) =

f) Breakeven point (sales is shs.) for a multi-product firm =

Margin of safety
This is the amount by which actual sales may fall before incurring a loss. It measures the
risk that the company might make a loss if it fails to achieve the target. A high margin of
safety means a high profit expectation even if the budget or target is not achieved.
Margin of safety is given by:

Margin of safety = Expected sales- B E P sales X 100

Expected sales

Illustration 1
A company makes a single product with a sales price of sh.100 and a marginal cost of sh.60. fixed costs are
sh.600,000 p.a. calculate
a. Number of units to breakeven.
b. Sales at breakeven point.
c. Cost per sale ratio.
d. What level of sales will achieve a profit of sh.200, 000 p.a?
e. Because of increasing costs the marginal cost is expected to rise to sh.65 per unit and fixed costs to
sh.700,000 p.a. if the selling price cant be increased what will be the number of units required to maintain a
profit cost of shs.200,000 p.a.
f. It the taxation is 40% how many units will be sold to make a profit of sh.200,000 p.a.

Solution:
a) Breakeven point (in units) = = 15,000 units
b) B/EP in sales (sh.) = 15,000 units x sh.100 = 1,500,000
c) C/S ratio = = 40%
d) Number of units for target profit =
= 20,000 units
e) Sales for target profit = 20,000 x sh.100 = sh.200,000
Fixed Cost, Marginal Cost and contribution have changed, thus
Number of units for target profit = = 25,714 units

f) Number of units for target profit after tax = = 23,333 units.

Illustration 2
Novik Enterprises operate in the leisure and entertainment industry and one of its activities is to promote
concerts in Nairobi. The company is considering the viability of a concert in Nyeri town. Estimated FC is
sh.60, 000. These include fee to perform, the hire of venue and advertisement cost. Variables costs of a pre-
pocked buffet, which will be provided by a firm of caterers at a price, which is currently being negotiated, but
its likely to be in the region of sh.100 per ticket sold. The projected price for the sale of a ticket is sh.200. The
management of Novik have requested the following information:
i. The number of tickets that that must be sold to breakeven.
ii. How many tickets must be sold to earn sh.30000 target profit.
iii. What profit would result of 8000 tickets were sold?
iv. What selling price would be charged to give a profit of sh.300000 from the sales of 8,000
units?
v. How many additional tickets must be sold to cover the extra cost of television
advertisement of sh.8000?

Illustration 3
XYZ Company manufactures a product called “PERMA”. Pertinent cost and revenue data relating to the
manufacture of this product is given below:
Shs
Selling price per unit 66
Variable production cost per unit 44
Variable selling cost per unit 4

Fixed production cost (total) Shs.200,000

Fixed selling and administrative cost (total) Shs.99,000

Required
a) Calculate the break-even sales level in shillings;
b) Suppose the company desires to make a profit of shs.195, 000, what should be the output in units?
c) A new machine, which is more efficient, is installed. This machine increases the fixed production cost by
20% but reduces the variable production cost per unit by 30%. What is the new break-even point in sales
revenue?

C-V-P Analysis
Practice Question 1
The following data relate to Kenya Ltd for the year ended 31 December 2009.
Sh ‘000’
Sales 24,000
Less: Total costs 20,000
Net profit 4,000
Fixed costs account for 40% of the total costs.

Required:
i) Margin of safety. (2 marks)
ii) Break-even point in sales (2 marks)
iii) Sales required to earn profit of Sh 6,000,000. (2 marks)
iv) In order to increase sales, the management has the following two options:
1. To increase sales by 25% on incurring a sales promotion cost of
Sh 2,500,000.
2. To increase sales by 15% on reducing selling price by 5%.
Advise the management on which option they should take. (8 marks)

Practice Question 2
Auto Robot Ltd which manufactures two products P & Q has provided the following
Information.
P (shs) Q (shs)
Selling price per unit 10 12
Variable cost per unit 2 8
Fixed cost 50,000 34,000
Required:-
i. Calculate the B. E. P. of each product in units and in shs.
ii. Calculate the margin of safety if budgeted sales are 10,000 units each
iii. Compute the profit of each product if sales in units are 20% above the B. E. P.

Question 4
a) State and briefly explain three assumptions underlying the break-even theory. (6 marks)
b) Jamii Company Ltd manufactures and sells a single product. The following information regarding the
company’s operations for the year ended 30 September 2001 was presented to you.
c)
Profit and loss account for the year ended 30 September 2001
Sh’000 Sh’000
Sales 30,000
Less:
Production costs
Direct material 6,500
Direct labour 5,400
Production overhead variable 7,000
Prime costs 18,900
11,100
Other expenses:
Selling – Variable 2,600
- Cost 1,997
Administration 2,100 6,697
Net profit 4,403

The following changes are expected to occur during the year ending 30 September 2002:
1. Selling price will be adjusted downward by 3% in order to attract more customers.
2. Material prices will rise by 2% due to inflation.
3. There will be a reduction in labour cost of 4%.
4. Production overheads will increase by 3%.
5. Increase in the efficiency of sales persons will reduce direct selling costs by 5%.
All other factors are expected to remain constant.

Required:
a) Break-even point in sales value (4 marks)
b) The margin of safety in sales value (2 marks)
c) The sales value at which profit of Sh 4.5 million will be achieved (2 marks)
d) A summary operating statement that shows the net profit of Sh 4.5 million in (c) above.
(6marks)

Question 5
Assume that a company intends to sale product in the market, at a selling price
of sh.9 per unit. The variable Cost is shs.5 per unit and the total Fixed Cost is sh.2000
Required:
i. Compute the B E P in units and in shs.
ii. Assume that the company intends to make a profit before tax of 20% of sales, determine the number of
units that must be sold.
iii. Assume that the corporate tax rate is 30% and the company has a target profit of sh.1640 after tax.
Compute the number of units that must be sold to earn this target profit.
iv. If the company expects to sale 600 units, compute the marginal of safety.

Practice Question 6
A tour company has fixed cost estimates costs of Ksh 60,000 a variable cost of Ksh 10 for each ticket sold
and a proposed ticket sale price of Ksh 20. Use the graphical method to determine the break-even point.

SOLUTION TO Q4
Assumption of Break-even analysis
1) The behaviour of total costs and total revenues applies to relevant range only.
CVP analysis is appropriate only for decisions taken within the relevant production range. It is incorrect to
project cost and revenue figures beyond the relevant range. Relevant range refers to the output range at which
the firm expects to be operating in the future and is equivalent to normal capacity. It represents the output
levels which the firm has had experience of operating in the past and for which cost information is available.

2) All costs can be divided into fixed and variable elements.

CVP analysis assumes that costs can be accurately analyzed into their fixed and variable elements.

3) The analysis either covers a single product or assumes that a given sales mix will be maintained as total
volume changes. CVP analysis assumes that either a single product is sold, or if a range of products is sold
that sales will be in accordance with a predetermined sales mix.

4) Volume is the only relevant factor affecting costs: all other variables remain constant.
It is assumed that all variables other than volume remain constant throughout the analysis. i.e changes in
other variables such as production efficiency, sales mix price levels and production methods do not have an
influence on sales revenue and costs.

5) Single product or constant sales mix.

CVP analysis assumes that either a single product is sold or if a range of products are sold those sales will be
in accordance with a predetermined sales mix.

6) Profits are calculated on variable costing basis i.e. the volume of sales or changes in beginning and ending
inventory levels are insignificant in amount. The analysis assumes that fixed costs incurred during the period
are charged as an expense for that period. Therefore variable costing profit calculations are assumed. I f
absorption costing profit calculations are used; it is necessary to assume production is equal to sales.

7) Total costs and total revenue are linear functions of output.

The analysis assumes that unit variable cost and selling price are constant.
(B)
Shs. ‘000’

Sales 30,000 x 0.97 29,100

Less Cost of Sales
Materials 6,500 x 1.02 6,630
Labour 5,400 x 0.96 5,184
Production overhead (7,000 x 1.03) 7,210
Cost of Sales (19,024)
10,076
Less other variable costs (2,600 x 0.95) (2,470)

CONTRIBUTION 7,606
Less Expenses
Fixed 1997
Administration 2100 (4,097)
NET PROFIT 3,509
a) B.E.P (shs) = Fixed Costs = 4,097,000 x 29,100,000
 C/S ratio 7,606,000

= shs 15,674,823

b) Margin of Safety = Budgeted sales – Break even sales

= 29,100,000 – 15674823
= shs 13,425,177

c) Sales value at which profit of sh. 4.5m will be achieved.

Use:
Profit = Contribution – Fixed costs, thus,
Profit = (P – V) X – Fixed costs when X is sales in units.
or
Profit = C/S X – Fixed Costs.
when X is sales in shs.
P – selling price per unit
V- variable cost per unit
C/S – contribution sales ratio

Profit = C/S X – Fixed costs.

4,500,000 = 7,606 X – 4,097,000
29100
X = Shs. 32,891,493.

d) Sales 32,891,493
Less Variable Cost 24,294,493 {32,891,493/29,100,000 x (19,024,000+2,470,000)}
CONTRIBUTION 8,597,000
Less Expenses (4,097,000)
NET PROFIT 4,500,000

Solution Question 5
i) B.E.P (in units) = 2000/4= 500 units
B.E.P (in Shs) = 2000/4*9 = Sh 4,500/=
ii) No of units = F.C + Target Profit

Contribution/unit
x = 2000+0.2*x*9 = approx. 909 units
4
iii) No. of units = 2,000 + 1640 = 1085.7
1- 0.3
iv) M.O.S = 600-500=100 units