Chapter 2: Cost-volume-profit analysis

1) Economist’s CVP model

2) Accountant’s CVP model
3) CVP analysis: a mathematical approach
4) CVP analysis in a multi-product analysis
5) CVP analysis assumptions
CVP Analysis

• Cost-volume-profit (CVP) analysis examines the relationship

between changes in activity (output / production) and changes
in total sales revenue, costs and net profit.

i.e. most important variables influencing total sales revenue, total

costs and profits is output or volume

hence management can concentrate on output levels to determine

for e.g. what are critical output levels to breakeven (i.e. neither a
profit or loss will occur)
CVP Analysis

• CVP analysis is based on relationship between volume / output and

total sales revenue, total costs and profit in the short run (a year or
less) where output is restricted to current operating capacity

some inputs can be changed in the short run (e.g. additional

supplies of raw material in short notice) but others cannot be
changed in the short run (e.g. expanding or reducing operating
capacity of co)

hence, output is limited in the short run as co must operate

within restricted capacity (cannot expand capacity) or operate at a
relatively constant production level (cannot reduce capacity)

• Another area of uncertainty is sales volume

thus, CVP analysis examines how changes in sales volume

affects changes in totals sales revenue, total costs and
profitability in the short run
1) Economists CVP Model: Figure 2.1

fixed costs

A-B:When co. operates at lower volume levels (below operating capacity), costs rises steeply,
because although lower volumes are produced, fixed costs incurred is the same (fixed) and hence
costs rises steeply above revenue.
B-C: At B, the co. breakevens and from B-C the co. is operating at efficient / full capacity. Hence,
co.’s costs rises less and total revenues start increases. At full capacity, co. benefits from
specialisation of labour & smooth production.
C-D:Here, the co. is operating beyond its capacity level & hence bottlenecks; complex production;
& plant breakdowns occur causing reduced output per direct labour hour. Here, cost per unit of
output will increase (more direct labour hour required) and totals costs will also increase. Also
here, for the co. to increase sales quantity, it must reduce unit selling price (high competition)
causing totals sales revenues to decline to a point where another breakeven point is reached (C).
After this, the combination of increased total costs & reduced selling price outweighs the benefits
of increased sales volume.
Economists CVP Model: Figure 2.2

From pt.0: Initially from this pt., production volume is lower and hence variable costs are high
(discounts on raw materials are less as purchases are less; also lesser produced per direct
labour hour).
0-Q1: However, as production expands, purchase of material increases (bulk discounts
obtained) & there is division of labour (specialisation) here, material and labour cost per
unit reduces increasing returns to scale
Q1-Q2: Here, variable costs levels out as co. is operating at efficient / full capacity and hence
variable costs are much lower and stable. However, it cannot reduce further as further
economies of scale is not achievable in the short run (i.e. some inputs such as capacity of
plant and machinery cannot be changed).
From Q2 onwards: Here, co. is operating beyond the capacity and bottlenecks and breakdowns occur
causing output per direct labour hour to reduce in turn causes variable costs to increase
decreasing returns to scale (pt. C-D in Figure 2.1)
2)Accountant’s CVP Model

• Accountant’s model assumes that variable cost per unit and

selling price per unit is constant

this results in a linear relationship

(I) between total cost and volume changes &
(II) between total revenue and volume changes

hence since both total cost and revenue are linear with volume
changes (i.e. increased volume results in increased cost and
revenue), there is only 1 breakeven point

profit increases as volume increases, hence most profitable

output is at maximum practical capacity

however, the economist’s model is more realistic as it is non-linear

Accountant’s CVP Model: Figure 2.3

Relevant Range:
1) Accountant’s model is not intended to provide accurate representation of total costs and total
revenue throughout all ranges of output
2) Accountant’s model is only intended to represent total costs and total revenue within a particular
range of output Relevant Range this range represents the output range that the co.
intends to operate within the short term this range is based on the co.’s past operating
experience where cost information is already available.
3) X-Y(Relevant range): Within this range, the total cost line is similar to that of the economist’s (that is
why accountant’s model is a good representation only in the relevant range). Here, the variable cost
per unit is same throughout this range and hence total cost is linear with levels of output within this
range only. This assumption does not apply outside the range (not good representation outside the range).
Accountant’s CVP Model: Figure 2.4: Fixed Cost

0-A:In the short term, the co. expects to operate within the relevant range (maximum operating
capacity), i.e. between outputs Q2-Q3 and hence the fixed cost committed here is between 0-A.
0-B: However, if the co. goes through a prolonged economic recession [e.g. demand for sales
drops and hence sales volume drops leading to reduced production (below Q1)], could lead to
redundancies and shutdowns. As such, fixed cost will not be utilised and drop to 0-B (basic
operating capacity).
Above Q3: In the longer term, if sales volume is expected to increase above Q3, then additional
fixed costs will be needed at different ranges of output.
Hence, the accountant’s model is made to accurately represent fixed cost only in the
relevant range and not the areas outside this range.
Accountant’s CVP Model: Total Revenue Function

• According to the accountant’s model, selling price per unit is also

constant with volume

hence, total revenue will have a linear relationship with volume

changes

this assumption is only realistic for co.s that operate in industries

with a fixed selling price per unit in the short term (i.e. the relevant
range) i.e. industries that do not compete with prices, for e.g.
high end goods that compete on brand name and superiority.

Therefore, the accountant’s model of a fixed selling price in

the short term (relevant range) is accurate

however, beyond this range, the accountant assumes that further

increases in sales volume / output is only possible with
substantial reductions in selling price
3)CVP: A Mathematical Approach

Example 2.1: Refer to text pg.172

Fixed costs per annum £60 000
Unit selling price £20
Unit variable cost £10
Relevant range 4 000 - 12 000 units
NP: net profit; x: units sold; P: selling price; b: variable cost; a: fixed cost

1) Break-even point
(i) Fixed costs = £60 000/£10 = 6 000 units
Contribution per unit

(selling price – variable cost)

or (ii) NP = Px – (a + bx) 0 = 20x – (60,000 + 10x)

60,000 = 20x -10x
6000 = x

Hence, units sold to breakeven is 6,000 units

CVP: A Mathematical Approach
2. Units to be sold to obtain a £30 000 profit:
(i) Fixed costs + desired profit = (£60,000 + £30,000) / £10
Contribution per unit = £90 000/£10
= 9 000 units

or (ii) NP = Px – (a + bx) £30,000 = 20x – (£60,000 + 10x)

£90,000 = 20x -10x
9,000 =x

Hence, units sold to reach a target profit of £30,000, is 9,000 units

3. Profit from the sale of 8,000 units

NP = Px – (a + bx) NP = £160,000 – (£60,000 - £80,000)

= £20,000

Hence, if 8,000 units sold, net profit is £20,000

CVP: A Mathematical Approach
4. Selling price to be charged if £30,000 NP and 8,000 units sold

NP = Px – (a + bx) £30,000 = 8,000P – (£60,000 + £80,000)

P = £170,000 / 8,000 = £21.25

Hence, selling price to meet target profit of £30,000 and 8,000 units of sales is
£21.25

5. How many units more to sell if there is extra fixed cost of £8,000

Extra Fixed costs = £8,000/£10 = 800 units

Contribution per unit

Note: unit selling price and variable cost is assumed to be constant and hence
contribution per unit is also constant.
Hence extra 800 units of sales volume needed to cover fixed cost of £8,000.
CVP: A Mathematical Approach
6. Profit-volume ratio (PV) (contribution margin ratio)
It represents the proportion of each £1 of sales available to cover fixed costs and
provide a profit. Because, selling price per unit and contribution margin per unit is
constant, the PV ratio is also constant and hence either one of these formulas can
be used: -
(i)Profit volume ratio = Contribution per unit or Total contribution
Selling price per unit Total sales revenue

= £10 / £20 = 50% = £0.50

Hence, for each £1 of sales, a contribution of £0.50 is earned

(ii)If total sales is now £200,000, what will be the total contribution?

Total contribution = Total sales revenue x PV ratio

= £200,000 x £0.50 = £100,000

(iii) Hence, NP = (Sales revenue x PV ratio) – Fixed cost

Net profit = ( Total contribution ) - Fixed Cost

= £100,000 - £60,000 = £40,000
CVP: A Mathematical Approach

7. Relevant Range

- CVP analysis can only be used within the relevant range and anything outside
this range is not applicable or accurate.

Within this range, variable cost per unit and selling price per unit is constant.

In this e.g., caterer’s charges will be higher if sales of tickets are below 4,000 units
and lower if sales of tickets are above 12,000 units. Hence, variable cost of £10
per unit will remain constant within 4,000 units – 12,000 units (i.e. thus this
is the relevant range)

Also the number of seats in the venue is flexible and hence the hire cost is lesser if
ticket sales are below 4,000 units but higher if ticket sales are above 12,000 units.
Hence, fixed cost remains constant only within 4,000 units – 12,000 units
(i.e. the relevant range)
CVP: A Mathematical Approach

8. Percentage margin of safety

how much sales may decrease before a loss occurs, i.e. last point of safety

Expected sales - Break-even sales

Expected sales

- At breakeven, sales units were 6,000 tickets at a sales value of £120,000 (6,000
tickets x £20 sales price)

- Expected sales were 8,000 tickets at a sales value of £160,000 (8,000 tickets x
£20 sales price)

- Hence margin of safety = £160,000 - £120,000 = 25% of expected sales

£160,000

i.e. sales may decrease up to 2,000 tickets at a sales value of £40,000 before
a loss occurs (to the pt of BEP, after that a loss starts)
4) CVP analysis: Multi-product setting
BBB Co. sells two types of products, Product X & Product Y. Below is the
information based on sales forecast for the period:-

Product X Product Y Total

(£) (£) (£)
Sales volume 1,200 units 600 units 1,800 units
Unit selling price 300 200
Unit variable cost 150 110
Unit contribution 150 90
Total sales revenue 360,000 120,000 480,000
(-) Total variable cost 180,000 66,000 246,000
Contribution to direct
& indirect fixed cost 180,000 54,000 234,000
(-)Direct fixed cost 90,000 27,000 117,000
Contribution to indirect
fixed cost 90,000 27,000 117,000
(-) Indirect fixed cost 39,000
Operating profit 78,000
========
Direct fixed cost: fixed cost directly attributable to individual product, i.e. is avoidable
if that individual product is not produced / sold.
Indirect (common fixed cost): fixed cost that represent cost of common facilities, i.e.
is only avoidable when both products are not produced / sold.
CVP analysis: Multi-product setting

However the co. is concerned that actual sales may be less than forecasted and
hence requested for breakeven details.

(i) Breakeven point for Product X = Direct fixed cost / Contribution per unit
= £90,000 / £150
= 600 units

Breakeven point for Product Y = £27,000 / £90

= £300 units

- However, these breakeven point covers only direct fixed costs and not the
indirect fixed costs, hence a loss equal indirect fixed costs will be reported.
Therefore, the breakeven point for the co. as a whole must be ascertained.
CVP analysis: Multi-product setting

- Because indirect fixed costs cannot be identified with specific products, co. needs to
change sales volume to standard batches of products with a sales mix

Sales for Product X = 1,200 units & for Product Y = 600 units

Hence, for each standard batch of products, sales mix is 1,200:600 or 2:1

i.e. for every 2 of Product X sold, 1 Product Y is sold

Hence, for each standard batch, contribution per unit = [(X: 2 x £150) + (Y: 1 x £90)]
= £390

Breakeven point = Total fixed cost / Contribution per batch

= £156,000 / £390
= 400 standard batches

Since sales mix per standard batch is 2:1,

Breakeven units for Prod.X = (2 x 400 batches) = 800 units
Breakeven units for Prod.Y = (1 x 400 batches) = 400 units
Total 1,200 units
4) CVP analysis: Multi-product setting

This budgeted profit statement proves breakeven point:

Product X(£) Product Y(£) Total (£)
Breakeven units 800 400 1,200
Unit contribution 150 90
Contribution to direct & indirect FC 120,000 36,000 156,000
(-) Direct FC 90,000 27,000 117,000
Contribution to indirect FC 30,000 9,000 39,000
(-) Indirect FC 30,000 9,000 39,000
Operating profit (breakeven) 0
=====
4) CVP analysis: Multi-product setting

Lets says, actual sales volume for the period is 1,200 units; 600 units of Prod.X
and 600 units of Prod.Y.

Hence the sales mix per standard batch is 600: 600 or 1:1

i.e. for every 1 Prod.X sold, 1 Prod.Y was be sold

Actual contribution per batch = [(X:1 x £150) + (Y: 1 x £90)] = £240

Therefore, actual breakeven point = £156,000 / £240

= 650 standard batches

Since actual sales mix per standard batch is 1:1,

Breakeven units for Prod.X = (1 x 650 batches) = 650 units
Breakeven units for Prod.Y = (1 x 650 batches) = 650 units
Total 1,300 units

Since actual sales was only 1,200 units, co. has incurred a loss
4) CVP analysis: Multi-product setting

This actual profit statement proves breakeven point:

Product X(£) Product Y(£) Total (£)
Breakeven units 650 650 1,300
Unit contribution 150 90
Contribution to direct & indirect FC 97,500 58,500 156,000
(-) Direct FC 90,000 27,000 117,000
Contribution to indirect FC 7,500 31,500 39,000
(-) Indirect FC 7,500 31,500 39,000
Operating profit (breakeven) 0
=====

Higher contribution margin products have lower breakeven point (e.g. in the
budgeted scenario) & lower contribution margin products have higher breakeven
point (e.g. in the actual scenario)
5) CVP analysis assumptions

CVP analysis assumptions

1. All other variables remain constant

- Sales volume is the only variable that changes and hence is the only variable
that affects costs & revenues.
- Although these variables (sales mix, production efficiency, price levels,
production methods) affect costs and revenues, significant changes in these will
distort CVP analysis

2. Single product or constant sales mix.

- CVP is based on single product sold.
- If multi products are sold, then it must be based on a predetermined sales mix.
Here, sales volume is based on standard batches of products

3. Total costs and revenues are linear with output

- selling price and variable cost per unit is constant in the relevant range only

4. Analysis applies to relevant range only

- CVP analysis is only accurate in the relevant range of product (capacity it has
been designed for). Costs and revenues beyond this range is inaccurate.
CVP analysis assumptions
5. CVP analysis only applies in the short term range
- CVP analysis is the relationship between volume and sales revenues, costs and profits in
the short run.
- In the short run, volume is unaffected by fixed costs but are affected by variable costs.
Hence, in the short run, volume is the most important variable that affects revenues, costs
and profits.

6. Profits are calculated on variable costing basis

- CVP analysis assumes that fixed costs are period costs and charged as an expense to the
period – variable costing basis

7. Costs can be accurately separated into its fixed and variable elements
- Semi- variable costs [e.g. maintenance costs that are pre-planned (fixed) and needed for
amount of activity usage (variable)] must be separated into its fixed and variable elements to
make CVP analysis accurate.
High-low method
E.g.: Lowest activity: 5,000 units with indirect costs of £22,000
Highest activity: 10,000 units with indirect costs of £32,000

Hence, variable element = Difference in cost / Difference in activity

= £10,000 / 5,000 units = £2 per unit of activity

Hence, fixed element for 5,000 units = £22,000 – (£2 x 5,000) = £12,000
10,000 units = £32,000 – (£2 x 10,000) = £12,000
 Reference
Colin Drury, Management and Cost Accounting,
9th Edition, Cengage Learning EMEA.
ISBN 978-1-4080-9393-1