LESSON THREE

BASIC COST VOLUME AND PROFIT ANALYSIS

4.1 Introduction
In this lesson, we introduce Cost-Volume-Profit (CVP) analysis, methods of CVP analysis,
volume analysis and revenue analysis and break-even-point, problems solving including
margin of safety, profitability and multi-products.
4.2 Lesson Learning Outcomes
At the end of this lesson, you should be able to:
4.2.1 Explain the meaning.
4.2.2 Explain assumptions and decisions of CVP analysis.
4.2.3 Determine the break-even-point.
4.2.4 Apply CVP analysis: Sensitivity Analysis
4.2.5 Multi-Period CVP analysis.
4.2.6 Calculate margin of safety.
4.2.7 Calculate of profitability.
4.2.8 Explain Multi-product CVP analysis.
4.2.9 Explain graphical method of CVP.

4.2.1 Explain the meaning of CVP analysis

Profit planning is the fundamental function of management. In profit planning it is important
to study all the factors that affect profit. The key factors that affect profit are cost, volume
and price. Cost-Volume and Profit (CVP) analysis is therefore the technique that is used to
determine how profit behaves as a result of changes in cost, volume and price. Cost refers to
expenses while volume implies sales value or production output. CVP analysis is in fact the
actual starting point of profit planning. A change in sales volume is likely to cause a change
in cost and a subsequent change in profit. Therefore, business managers need to understand
the inter-relationship that may exist between cost, volume and price.

Profit planning is a function of selling price, variable cost of making the product and sales
volume of the product and fixed cost. In multi-product the sales mix of products. CVP is
applied to long term production of a business and uses cost behaviour theory to determine
quantity to be produced and sold at break-even point. It is sometimes called break even
analysis. It also used to determine volume or revenue for desired profit.

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4.2.2 Explain assumptions and decisions of CVP analysis.

Assumptions of CVP Analysis

 Costs are divided into fixed and variable costs.
 Fixed cost to remain constant over a relevant range.
 Variable cost to remain constant within a relevant range.
 Selling price to remain constant irrespective of sales.
 Production and sales volume are the same.

Decisions to be made under Cost-Volume-Profit

 What sales volume is necessary to achieve a given level of operating profit?
 What will be operating profits for a given sales volume and revenue?
 What is the margin of safety offered by expected sales volume?
 What additional sales required making good reduction in selling price?
 What will be effect on operating profit if the fixed cost increased?
 What will the effect on operating profit if there is a reduction in variable cost?
1. https://accountingexplained.com/managerial/cvp- analysis/
https://www.youtube.com/watch?v=Nw2IioaF6Lc
2. https://courses.lumenlearning.com/sac-managacct/chapter/the-income-equation-and-
contribution-margin-techniques/
3. https://nicoletcollege.pressbooks.pub/1010214500busfin/chapter/cost-volume-profit-
analysis/

4.2.3 Determine the break-even-point.

Break even analysis can be determined using the following methods:

(a) Algebraic method

Contribution margin approach
Equation technique
(b) Graphic presentations
Break even chart
Profit volume graph

Contribution Approach
(i) Volume Analysis

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 (a) Break-even point
The fundamental importance of break-even is the determination of the level of production or
level of sales at which the business is to break- even. This level of activity is known as the
break- even point (BEP). At the break-even point, TR=TC. Any marginal increase in sales
above the break-even point will result into profit while a decrease will result into loss. The

equation for computation of break-even point is stated is, =

Where; FC = Fixed Cost,

SP = Selling Price
VC= Variable Cost
C= Contribution
Contribution= Selling Price – Variable Cost
From this basic formula, several formulae can now be derived based on the decision to be
made.
Fixed Cost, Variable Cost and Contribution can be expressed either as total or per unit.
(b) Volume to achieve a level of desired profit

(ii) Revenue Analysis

(a) Break-even point

In revenue analysis we consider profit-volume P/V ratio

P/V ratio =Contribution margin/selling price

Break-even point =

Break-even point=

(b) Revenue for desired profit

1. https://hbr.org/2014/07/a-quick-guide-to-breakeven-analysis
2. https://www.youtube.com/watch?v=BqcwVCu8vjQ
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 3. How Is Cost-Volume-Profit Analysis Used for Decision Making? (saylordotorg.github.io)
Illustration

A company is producing a single product with the following information:

Selling price per unit Kshs 500
Variable cost Kshs 300
Fixed Cost of production Kshs 6,000,000
You are required to determine:
(a) Contribution margin
(b) P/V ratio
(c) Break even units and revenues
 Units and Revenues to achieve desired profits of Kshs 5,000,000
 Contribution margin = selling price – total production variable cost
= Kshs 500-(100+100+50+50) = Kshs 200
 P/V ratio = Contribution margin/ selling price
= Kshs 200/Kshs 500= 2/5
 Break-even point units = fixed cost/contribution margin
=Kshs 6,000,000 / Kshs 200 = 30,000 units
 Break-even point revenues= fixed cost/P/V ratio
= Kshs 6,000,000 /2/5= Kshs 15,000,000

 Units to achieve desired profits of Kshs 5,000,000

= (fixed cost + desired profit)/contribution margin
= Kshs 6,000,000+ Kshs 5,000,000)/Kshs 200
= Kshs 11,000,000/Kshs 200 = 55,000 units
 Revenues to achieve desired profits of Kshs 5,000,000
= (fixed cost + desired profit)/P/V
= Kshs 6,000,000+ Kshs 5,000,000)/2/5
= Kshs 11,000,000/2/5 = Kshs 27,500,000

4.2.4 Application of CVP analysis: Sensitivity Analysis

CVP sensitivity analysis involves determining the effect on profitability when changing the
values of a variable(s) while holding others constant. It is used to determine effect of:

(i) Changes in fixed cost

(ii) Changes in variable costs
(iii) Changes in selling price
(iv) Taxation

Given the illustration in 4.2.3 Calculate required sales volume and sales revenues to achieve
required level profit if:

(i) Taxation rate is 30%

(ii) Variable costs increase by Kshs 100

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 (iii) Variable cost decreases by Kshs 50.
(iv) Fixed cost increases by Kshs 1,000,000

4.2.5 Multi Period and Multi Divisions CVP analysis: Sensitivity Analysis
CVP analysis can be determined for different periods and different factories, departments or
divisions. The P/V ratio for multi-period is = Change in Profits/Change in sales.
Illustration:
Nairobi Limited furnishes you with the following information for the current year divided into
two parts:
First half (Kshs) Second half (Kshs)
Sales 810,000 1,026,000
Profits earned 21,000 64,800
If fixed cost remains the same, calculate:
(a) profit/volume ratio
(b) fixed cost
(c) amount of profit or loss when sales are Kshs 648,000
(d) amount of sales required to earn a profit of Kshs 108,000
Solution:
(a) Once the BEP is attained, the firms operating profit increases in direct proportion to
the P/V ratio can be calculated as follows.
Profit = ksh.43, 200 100 20
Sales Kshs. 2,160,000
(b) Variable cost/ Volume ratio 80 (100 -20 )
Sales revenue = Fixed costs + Variable costs + profit
Kshs. 1,836,000 = Fixed costs + 80 (kshs. 1,836,000) + Kshs. 86,400
1,836,000- Kshs. 1,555,200= Fixed costs
280.800 = Fixed costs
(c) Income statement when sales are Kshs 648,000
Sales revenue Kshs 648,000
Less variable cost 80 Kshs 518,400
Contribution Kshs 129,600
Less fixed costs Kshs 280,800
Loss Kshs (151,200)

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 (d) Required sales volume to earn profit
= Fixed costs + desired profit
P/V ratio
= Kshs. 280,800+ Kshs 108,00 = Kshs . 388,800 = Kshs. 194,400
20 20
Illustration
There are two similar plants under the same managements. The management desire to merge
these two plants. The following particulars are available:
Factory 1 Factory 2
Capacity 100 60
Sales Kshs.300 Kshs.120
Variable costs 220 90
Fixed costs 40 20
You are required to calculate.
(a) What the break –even capacity of the merged plant would be
(b) What the profitability on working 75% of the merged capacity would be.

Solution:
(a) Factory 1 Factory 2 Combined
(at 100% (at 100% (at 100%
Capacity) capacity) capacity)
Sales Kshs. 300 Kshs. 200 Kshs 500
Less Variable cost 220 150 370
Contribution 80 50 130

Break –even volume in Kshs. = Fixed costs

Combined P/V ratio
= Kshs. 60 = Kshs. 230.8
26%
26% = Kshs. 130 100
Kshs. 500
Break-even point (% capacity) = Break even sales 100
Total Capacity

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 = Kshs. 230.8 100 = 46.15%
Kshs. 500
The break – even point capacity of the merged plant would be approximately 46.15%

(b) Income statement at 75% merged capacity.

Sales Kshs. 375.00
Less variable cost (74% v/v ratio) Kshs. 277.50
Contribution Kshs. 97.50
Less: Fixed costs Kshs. 60.00
Net profit Kshs. 37.50

Alternatively, (Actual sales – BE sales) P/V ratio

= (Kshs. 375- Kshs. 230.765) 26% = Kshs. 37.50

4.2.6 Calculation margin of safety.

Margin of safety is a measure of the extent to which actual sales cover the break-even sales.
Margin of safety can be expressed in the form of ratio or revenue. Margin of safety (MOS) is
the difference between actual sales and break-even sales. In other words, all sales revenue
above the break-even point represents the margin of safety.
https://www.accountingformanagement.org/margin-of-safety/

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Illustration
A company is producing a single product with the following information:
Selling price per unit Kshs 500
Material cost per unit Kshs 100
Labour cost per unit Kshs 100
Direct expenses Kshs 50
Factor Overheads Kshs 50
Fixed Cost of production Kshs 6,000,000
You are required to determine:
(d) Contribution margin
(e) P/V ratio
(f) Break even units and revenues
(g) Units and Revenues to achieve desired profits of Kshs 5,000,000
(h) Margin of safety revenue and volume
(i) Margin of safety ratio.
(j) profitability
 Contribution margin = selling price – total production variable cost
= Kshs 500-(100+100+50+50) = Kshs 200
 P/V ratio = Contribution margin/ selling price
= Kshs 200/Kshs 500= 2/5
 Break-even point units = fixed cost/contribution margin
=Kshs 6,000,000 / Kshs 200 = 30,000 units
 Break-even point revenues= fixed cost/P/V ratio
= Kshs 6,000,000 /2/5= Kshs 15,000,000

 Units to achieve desired profits of Kshs 5,000,000

= (fixed cost + desired profit)/contribution margin
= Kshs 6,000,000+ Kshs 5,000,000)/Kshs 200
= Kshs 11,000,000/Kshs 200 = 55,000 units
 Revenues to achieve desired profits of Kshs 5,000,000
= (fixed cost + desired profit)/P/V
= Kshs 6,000,000+ Kshs 5,000,000)/2/5
= Kshs 11,000,000/2/5 = Kshs 27,500,000
 Margin of safety ratio using volume:
= (Actual volume for desired profit - Break-even point
volume)/ Actual sales for desired profit) * 100%
=(55,000 units-30,000 units)/55,000 units * 100%

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 =45.45%
 Margin of safety ratio using revenue:
= (Actual sales for desired profit - Break-even point
sales)/ Actual sales for desired profit) * 100%
=(Kshs 27,500,000-Kshs 15,000,000)/Kshs 27,500,00)*
100%
=45.45%

4.2.7 Calculation of profitability.

Profitability is the difference between sales revenue and total costs. It is also determined by
multiplying margin of safety revenue by P/V ratio or margin of safety volume by contribution
margin.

Revenue analysis:

Margin of safety revenue = Sales revenue for desired profit-break even sales revenue

= Kshs 27,500,000-Kshs 15,000,000) = Kshs 12,500,000

Profitability = Margin of safety revenue * P/V ratio

= Kshs 12,500,000 * 2/5 = Kshs 5,000,000

Volume analysis:

Margin of safety volume = Sales volume for desired profit-break even sales volume

= 55,000 units-30,000 units = 25,000 units

Profitability = Margin of safety volume * contribution margin

= 25,000 units * Kshs 2,000 = Kshs 5,000,000

1. https://courses.lumenlearning.com/sac-managacct/chapter/the-income-equation-and-
contribution-margin-techniques/
2. https://nicoletcollege.pressbooks.pub/1010214500busfin/chapter/cost-volume-profit-
analysis/
3. https://www.youtube.com/watch?v=fyAEVKCSjcI&feature=emb_logo

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4.2.8 Examination Multi-Product Cost Volume Profit Analysis
Many companies make more than one type of product. The relative proportion of each sold in
the aggregate sales is known as the sales-mix. A change in the sales mix of the product sold
usually affects the weighted average P/V ratio and, hence the BEP. This is when the products
have different P/V ratios; change in the sales-mix will affect the BEP and the results of
operation.
Illustration
Examine the break-even sales for the following data for a company producing three products
brand names A,B and C.
Products Sales (Kshs.) Variable Costs (Kshs.)
A 10,000 6,000
B 5,000 2,500
C 5,000 2,000
20,000 10,500
Total fixed Cost Kshs. 5,700
Calculate weighted P/V ratio and Break-even point
Products Sales (Kshs) Variable Costs (Kshs) Contribution (Kshs)
A 10,000 6,000 4,000
B 5,000 2,500 2,500
C 5,000 2,000 3,000
Total 20,000 10,500 9,500

Total contribution =Total sales-Total Variable costs = Kshs. 20,000-10,500 = Kshs. 9,500
Weighted P/V ratio = Total contribution/total sales = Kshs. 9,500/Kshs.20,000 = 0.475
BEP= Fixed cost/Weighted P/V ratio =Kshs. 5,700/ 0.475 = Kshs. 12,000
1. https://www.youtube.com/watch?v=lyZJLd7evXg
2. https://courses.lumenlearning.com/sac-managacct/chapter/the-income-equation-and-
contribution-margin-techniques/

4.2.9 Explanation of graphical method of CVP.

Graphical technique can be used in CVP analysis. The two methods include CVP graph and
Profit Volume graph. Graphical methods are based on the same assumptions of CVP.

CVP Graph or Break-even chart

A graphic relationship between costs, volume and profit, it shows not only BEP but also the
effect of costs and revenues on varying levels of sales. It can therefore be more appriopate
to be called CVP graph.

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 Illustration

Prepare BEP graph having the following information.

1. Selling Price per unit Kshs.100

2. Variable cost per unit kshs.50.
3. Fixed cost Kshs.6,000,000
4. The actual sales during the period were 180,000 units.

Solution

(a) Using contribution approach

Contribution margin = Kshs 100- Kshs 50 = Kshs 50

Profit Volume ratio= Kshs 50/Kshs 100 = ½

BEP Volume = Fixed cost/ Contribution margin

= Kshs 6,000,000/Kshs 50 = 120,000 units

BEP Revenue = Fixed cost/ P/V ratio

= Kshs 6,000,000/ ½
= Kshs 12,000,000

Margin of safety volume = 180,000 units - 120,000 units = 60,000 units

Margin of safety revenue = Kshs 18,000,000 – Kshs 12,000,000 = Kshs 6,000,000

Margin of safety ratio= 60,000units/ 180,000 units = 33.33%

Margin of safety ratio = Kshs 6,000,000/Kshs 18,000,000 = 33.33%

Profitability = Margin of safety volume x contribution margin

= 60,000 units x Kshs 50 = Kshs 3,000,000

Profitability = Margin of safety revenue x P/V ratio

= Kshs 6,000,000 x ½ = Kshs 3,000,000

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(b)

Units Fixed Cost Variable Cost Total cost sales

0 6,000,000 0 6,000,000 0
20,000 6,000,000 1,000,000 7,000,000 2,000,000
40,000 6,000,000 2,000,000 8,000,000 4,000,000
60,000 6,000,000 3,000,000 9,000,000 6,000,000
80,000 6,000,000 4,000,000 10,000,000 8,000,000
100,000 6,000,000 5,000,000 11,000,000 10,000,000
120,000 6,000,000 6,000,000 12,000,000 12,000,000
140,000 6,000,000 7,000,000 13,000,000 14,000,000
160,000 6,000,000 8,000,000 14,000,000 16,000,000
180,000 6,000,000 9,000,000 15,000,000 18,000,000

20000000

18000000

16000000

14000000
Units
12000000
Fixed Cost
10000000 Variable Cost
8000000 Total cost
6000000 sales

4000000

2000000

0
1 2 3 4 5 6 7 8 9 10

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Profit Volume Chart

Portrays relationship between profits to volume and supplements the CVP graph. The
usefulness of P/V chart is that they show a direct relationship between sales, volume and
profits. Separate lines of costs, revenues are eliminated from the P/V chart is only profit
plotted. It is easier to understand as at portrays profits and volume relationship.

4000000
3000000
2000000
1000000
0
-1000000 1 2 3 4 5 6 7 8 9 10 Units
-2000000 Profits
-3000000
-4000000
-5000000
-6000000
-7000000

4.3 Formative Assessment

1. (a) Examine Cost-Volume-Profit analysis

(b) Examine assumptions of Cost-Volume-Profit analysis.
2. ABC is producing a single product with the following information:
Selling price per unit Kshs. 500
Material cost per unit Kshs. 100
Labour cost per unit Kshs.100

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 Direct expenses Kshs. 50
Factor Overheads Kshs. 50
Fixed Cost of production Kshs. 50,000
You are required to calculate:
(a) Contribution margin.
(b) P/V ratio.
(c) Break-even-points units and revenue.
(d) Units and Revenues to achieve desired profits of sh.30, 000.
(e) Margin of safety revenue and volume
(f) Margin of safety ratio using revenue and volume analysis
(g) Profitability using revenue and volume analysis
(h) Prepare CVP graph and P/V chart
3. There are two similar plants under the same management. The management desires to
merge the two plants. The following are information about the two plants:
Plant I Plant II
Capacity 100% 60%
Sales (Kshs) 600,000 240,000
Variable costs (Kshs) 440,000 180,000
Fixed cost 80,000 40,000
You are required to calculate:
(a) Break-even point of merged capacity
(b) Profitability on working at 75% of merged capacity

4.

(a) Examine the break-even sales for the following data for a company producing three
products with brand names X,Y and Z.
Calculate weighted P/V ratio and Break-even point
Products Sales (Kshs) Variable Costs (Kshs)
X 500,000 200,000
Y 300,000 150,000
Z 200,000 100,000
Total 1,000,000 450,000

Total fixed Cost Kshs. 250,000

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 (b) Examine the break-even sales for a firm producing four products with brand names
A,B, C and D. by calculating weighted Profit/Volume ratio and break-even point
Products Sales (sh.) Variable Costs (sh.)
A 100,000 60,000
B 80,000 40,000
C 60,000 20,000
D 50,000 10,000
Total fixed Cost sh. 40,000

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