Cost Volume Profit Analysis

Breakeven Analysis

Objectives:

Determine the number of units sold to break even or to earn target profit Use a CVP chart and a profit-volume chart to determine the breakeven point and the volume necessary to achieve a target profit Explain the impact of changing variable on CVP analysis Calculate and interpret the impact of sales mix considerations in CVP analysis

Cost-Volume-Profit Analysis
(CVP)

CVP analysis is also known as breakeven analysis. It is a systematic examination of the interrelationships between selling prices, sales and production volume, costs, and profits Fixed and variable costs need to be segregated so that variable costs and volume can be manipulated and changes in profit determined

Cost-Volume-Profit Analysis
(CVP)

The contribution margin is an important concept in CVP analysis. Fixed costs are incurred irrespective of sales, a firm will make a loss if the contribution margin is insufficient to cover fixed costs Breakeven point is the level of output at which firm makes zero profit, TC=TR

Contribution

Cost-Volume-Profit Analysis
(CVP)
Unit sales Revenue Variable costs Contribution margin Fixed costs Net profit 40,000 Total Unit 400,000 10.0 160,000 4.0 240,000 6.0 150,000 3.8 90,000 2.2 20,000 Total 200,000 80,000 120,000 150,000 (30,000) Unit 10.0 4.0 6.0 7.5 (1.5)

Total variable costs increase proportionally with output while unit variable costs are constant.
Total fixed costs remain constant but the unit fixed costs fall as the output rises because the fixed costs are spread across more output.

Traditional Breakeven Chart

Contribution Breakeven Chart

ProfitVolume Chart
Profit (+) Contribution

profit ()
0 Fixed costs

BEP
loss

Volume of activity (units)

Loss ()

Margin of Safety

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Breakeven Analysis

Assumptions made when using breakeven analysis

Fixed costs remain constant Variable costs very proportionally with volume of output All other factors remain unchanged. E.g., selling prices remain constant, methods and efficiency of production unchanged, volume is the sole factor affecting costs

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Breakeven analysis
The Equation Method
Sales = Variable costs + Fixed costs + Net profit
Example Unit sale price is 10, variable costs are 4 per unit, fixed costs are 150,000 per year. Current output is at 40,000 units but can be increased to 50,000 units. How many units to be produced in order to break even? Answer: Let x be the unit of production. The equation will be 10x = 4x + 150,000 + 0 6x = 150,000 x = 150,000/6 = 25,000 units

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Breakeven analysis
The Contribution Margin Method
This method uses contribution margin per unit of output that is required to cover fixed costs
Alternative 1: Using Unit Contribution Margin Example Using the same values, calculate the break-even volume of sales. Answer: Let x be the unit required. Unit contribution margin = Unit sale price - Unit variable costs x = (Fixed costs + Net profit) / Unit contribution margin x = (150,000 + 0) / (10 - 4) x = 25,000 units

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Breakeven analysis
The Contribution Margin Method
Alternative 2: Using Contribution Margin Ratio (P/V Ratio) Example Using the same values, calculate the break-even sales revenue Answer: We make use of the contribution margin ratio to calculate the sales revenue required to cover fixed costs. The contribution margin ratio is : = (Unit contribution margin / Revenue per unit) % = [(10 - 4) / 10 ] * 100% = 0.6 * 100% = 60% (P/V Ratio)

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Breakeven analysis
The Contribution Margin Method
Alternative 2: Using Contribution Margin Ratio (P/V Ratio) Example Using the same values, calculate the break-even sales revenue Answer: x= (Fixed costs + Net profit) / Contribution margin ratio(P/V Ratio) x = (150,000 + 0 ) / 60% x = 250,000

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CVP Analysis
Changes in Factors - Fixed costs
Example Unit sale price is 10, variable costs are 4 per unit, fixed costs are 150,000 per year. Current output is 50,000 units. What is the consequential effect of an increase of 15,000 in head office costs on the break-even level?
Original 500,000 200,000 300,000 150,000 150,000 (6/10)*100 60% After increase in fixed costs 500,000 200,000 300,000 165,000 135,000 (6/10)*100 60%

Sales Vairable costs Contribution margin Fixed costs Net profit

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Contribution margin ratio

CVP Analysis
Changes in Factors - Fixed costs

Example The new break-even point is = Fixed costs / Unit contribution margin = 165,000 / 6 = 27,500 units

Assuming all other things remain unchanged, a change in fixed costs will affect only the break-even point.

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CVP Analysis
Changes in Factors - Variable Costs
Example A 10% increase in raw materials is necessary to improve the quality of the products. Will there be an effect on the break-even point?
Original 500,000 200,000 300,000 150,000 150,000 (6/10)*100 60% After increase in variable costs 500,000 220,000 280,000 150,000 130,000 (5.6/10)*100 56%

Sales Vairable costs Contribution margin Fixed costs Net profit Contribution margin ratio

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CVP Analysis
Changes in Factors - Variable Costs
Example The new break-even point is = Fixed costs / Unit contribution margin = 150,000 / 5.6 = 26,786 units

All other things equal, a change in the variable costs will have the immediate effect on changing the contribution margin ratio, and the break-even point.

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CVP Analysis
Changes in Factors - Selling Price
Example
Assuming that the company decided to increase the selling price by 10%. This resulted in a 10% reduction in the sales volume. Other things equal, what will be the consequential effect?
Original Sales in units Sales revenue Variable costs Contribution margin Fixed costs Net profit 50,000 500,000 200,000 300,000 150,000 150,000 60% After increase in selling price 45,000 495,000 45,000 @ 11 180,000 45,000 @ 4 315,000 150,000 165,000 63.6%

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Contribution margin ratio

CVP Analysis
Changes in Factors - Selling Price
Example The new break-even point is = Fixed costs / Unit contribution margin = 150,000 / 7.0 = 21,429 units

When selling price changes, the effect it has on the sales volume depends on the price elasticity of demand

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CVP Analysis
Changes in Factors - Selling Price

In this example, we assumed that the elasticity of demand is unity, that means a 10% change in selling price will lead to the same percentage change in volume If the demand is elastic, i.e. >1, then 10% change in price will lead to large change in volume, i.e., 20%

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CVP Analysis
Changes in Factors - Selling Price If the demand is inelastic, i.e., <1, a 10% change in price will lead to small change in volume, i.e., 5% It is crucial for management to know the elasticity of demand curve to get their net profit prediction valid

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CVP Analysis
Changes in Factors - Selling Price
Elastic 40,000 440,000 160,000 280,000 150,000 130,000 Unity 45,000 495,000 180,000 315,000 150,000 165,000 Inelastic 47,500 522,500 190,000 332,500 150,000 182,500

Sales units Sales revenue (11) Variable costs (4) Contribution margin Fixed costs Net profit

When the demand is elastic, a 10% increase in price will lead to sharp fall in net profit For unity and inelastic demand, a 10% increase in price led to increase in net profit

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CVP Analysis
The Sales Mix

Besides making ST profit decision, CVP analysis also helpful in selecting the best sales mix Firms can use CVP to help in altering the existing sales mix by selling more of the product which has highest contribution margin, and the overall contribution margin and break-even point might improve

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CVP Analysis
The Sales Mix
Example

Assuming that Company X sells the following 3 products. If the firm could switch its sales to sell more of product B, reduce the 50% sales on product A & C, and assuming that the firm is able to maintain the same total sales 250,000. What effect it has on the contribution margin ratio and break-even point?
Before Product Selling Price Variable Costs Units Fixed Costs A 10 5 10,000 B 10 3 10,000 150,000 C 10 4 5,000

After

Units

5,000

17,500

2,500

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CVP Analysis
The Sales Mix
Product A 100,000 50,000 50,000 B 100,000 30,000 70,000 C 50,000 20,000 30,000 Total 250,000 100,000 150,000 150,000 NIL 60%
Total 250,000 87,500 162,500 150,000 12,500 65%

Before Sales
Variable costs Contribution margin Fixed costs Net profit Contribution margin ratio
Product

50%
A 50,000 25,000 25,000

70%
B 175,000 52,500 122,500

60%
C 25,000 10,000 15,000

After

Sales Variable costs Contribution margin Fixed costs Net profit Contribution margin ratio

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50%

70%

60%

CVP Analysis
The Sales Mix
Example The new break-even point is = Fixed costs / Unit contribution margin = 150,000 / 6.5 = 23,077 units Alter the sales mix will increase the contribution margin ratio by 5%, leading to a profit of 12,500 and lowering the break-even point from 250,000 to 230,770

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CVP Analysis
Benefits vs. Costs

Benefits

Costs

Enriches the understanding of the relationship between costs, volume, and prices as factors affecting profit Enables management to make assumptions which will assist in ST decision making

Assume that fixed costs are constant, variable cost and revenue curves are linear Assume that volume is the only factor affecting costs, price of cost factors and of product produced/sold remain unchanged

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