ACCA'suseofcookies.Weusecookiestopersonaliseyourexperience,andbyusingthesiteyouare consentingtothis.

Findmoreaboutcookiesandhowtomanageyoursettings
Acceptandclose

HOME

HELP&SUPPORT

MEDIACENTRE

TECHNICALACTIVITIES

GLOBALSITE

Home > Students > ACCAQualificationStudentJourney > Qualificationresources > ACCAQualification > F5PerformanceManagement > Technicalarticles

COST-VOLUME-PROFIT ANALYSIS
Costvolumeprofitanalysislooksprimarilyattheeffectsofdifferinglevelsofactivityonthe financialresultsofabusiness Inanybusiness,or,indeed,inlifeingeneral,hindsightisabeautifulthing.Ifonlywecouldlookintoa crystalballandfindoutexactlyhowmanycustomersweregoingtobuyourproduct,wewouldbeableto makeperfectbusinessdecisionsandmaximiseprofits. Takearestaurant,forexample.Iftheownersknewexactlyhowmanycustomerswouldcomeineach eveningandthenumberandtypeofmealsthattheywouldorder,theycouldensurethatstaffinglevels wereexactlyaccurateandnowasteoccurredinthekitchen.Therealityis,ofcourse,thatdecisionssuch asstaffingandfoodpurchaseshavetobemadeonthebasisofestimates,withtheseestimatesbeing basedonpastexperience. Whilemanagementaccountinginformationcantreallyhelpmuchwiththecrystalball,itcanbeofusein providingtheanswerstoquestionsabouttheconsequencesofdifferentcoursesofaction.Oneofthe mostimportantdecisionsthatneedstobemadebeforeanybusinessevenstartsishowmuchdowe needtosellinordertobreakeven?Bybreakevenwemeansimplycoveringallourcostswithout makingaprofit. Thistypeofanalysisisknownascostvolumeprofitanalysis(CVPanalysis)andthepurposeofthis articleistocoversomeofthestraightforwardcalculationsandgraphsrequiredforthispartofthePaper F5syllabus,whilealsoconsideringtheassumptionswhichunderlieanysuchanalysis.

THEOBJECTIVEOFCVPANALYSIS
CVPanalysislooksprimarilyattheeffectsofdifferinglevelsofactivityonthefinancialresultsofa business.Thereasonfortheparticularfocusonsalesvolumeisbecause,intheshortrun,salesprice, andthecostofmaterialsandlabour,areusuallyknownwithadegreeofaccuracy.Salesvolume, however,isnotusuallysopredictableandtherefore,intheshortrun,profitabilityoftenhingesuponit. Forexample,CompanyAmayknowthatthesalespriceforproductxinaparticularyearisgoingtobein theregionof$50anditsvariablecostsareapproximately$30. Itcan,therefore,saywithsomedegreeofcertaintythatthecontributionperunit(salespricelessvariable costs)is$20.CompanyAmayalsohavefixedcostsof$200,000perannum,whichagain,arefairlyeasy topredict.However,whenweaskthequestion:Willthecompanymakeaprofitinthatyear?,theanswer isWedontknow.Wedontknowbecausewedontknowthesalesvolumefortheyear.However,we canworkouthowmanysalesthebusinessneedstomakeinordertomakeaprofitandthisiswhereCVP analysisbegins. Methodsforcalculatingthebreakevenpoint Thebreakevenpointiswhentotalrevenuesandtotalcostsareequal,thatis,thereisnoprofitbutalso nolossmade.Therearethreemethodsforascertainingthisbreakevenpoint: 1Theequationmethod Alittlebitofsimplemathscanhelpusanswernumerousdifferentcostvolumeprofitquestions. Weknowthattotalrevenuesarefoundbymultiplyingunitsellingprice(USP)byquantitysold(Q).Also, totalcostsaremadeupfirstlyoftotalfixedcosts(FC)andsecondlybyvariablecosts(VC).Totalvariable costsarefoundbymultiplyingunitvariablecost(UVC)bytotalquantity(Q).Anyexcessoftotalrevenue overtotalcostswillgiverisetoprofit(P).Byputtingthisinformationintoasimpleequation,wecomeup withamethodofansweringCVPtypequestions.Thisisdonebelowcontinuingwiththeexampleof CompanyAabove. Totalrevenuetotalvariablecoststotalfixedcosts=Profit (USPxQ)(UVCxQ)FC=P(50Q)(30Q)200,000=P Note:totalfixedcostsareusedratherthanunitfixedcostssinceunitfixedcostswillvarydependingon thelevelofoutput. Itwould,therefore,beinappropriatetouseaunitfixedcostsincethiswouldvarydependingonoutput. Salespriceandvariablecosts,ontheotherhand,areassumedtoremainconstantforalllevelsofoutput

intheshortrun,and,therefore,unitcostsareappropriate. Continuingwithourequation,wenowsetPtozeroinordertofindouthowmanyitemsweneedtosellin ordertomakenoprofit,ietobreakeven: (50Q)(30Q)200,000=0 20Q200,000=0 20Q=200,000 Q=10,000units. Theequationhasgivenusouranswer.IfCompanyAsellslessthan10,000units,itwillmakealossifit sellsexactly10,000units,itwillbreakeven,andifitsellsmorethan10,000units,itwillmakeaprofit. 2Thecontributionmarginmethod Thissecondapproachusesalittlebitofalgebratorewriteourequationabove,concentratingontheuse ofthecontributionmargin.Thecontributionmarginisequaltototalrevenuelesstotalvariablecosts. Alternatively,theunitcontributionmargin(UCM)istheunitsellingprice(USP)lesstheunitvariablecost (UVC).Hence,theformulafromourmathematicalmethodaboveismanipulatedinthefollowingway: (USPxQ)(UVCxQ)FC=P (USPUVC)xQ=FC+P UCMxQ=FC+P Q=FC+P UCM So,ifP=0(becausewewanttofindthebreakevenpoint),thenwewouldsimplytakeourfixedcostsand dividethembyourunitcontributionmargin.Weoftenseetheunitcontributionmarginreferredtoasthe contributionperunit. ApplyingthisapproachtoCompanyAagain: UCM=20,FC=200,000andP=0. Q=FC UCM Q=200,000 20 ThereforeQ=10,000units Thecontributionmarginmethodusesalittlebitofalgebratorewriteourequationabove,concentratingon theuseofthecontributionmargin. 3Thegraphicalmethod Withthegraphicalmethod,thetotalcostsandtotalrevenuelinesareplottedonagraph$isshownon theyaxisandunitsareshownonthexaxis.Thepointwherethetotalcostandrevenuelinesintersectis thebreakevenpoint.Theamountofprofitorlossatdifferentoutputlevelsisrepresentedbythedistance betweenthetotalcostandtotalrevenuelines.Figure1showsatypicalbreakevenchartforCompanyA. Thegapbetweenthefixedcostsandthetotalcostslinerepresentsvariablecosts. Alternatively,acontributiongraphcouldbedrawn.WhilethisisnotspecificallycoveredbythePaperF5 syllabus,itisstillusefultoseeit.Thisisverysimilartoabreakevenchart,theonlydifferencebeingthat insteadofshowingafixedcostline,avariablecostlineisshowninstead. Hence,itisthedifferencebetweenthevariablecostlineandthetotalcostlinethatrepresentsfixed costs.Theadvantageofthisisthatitemphasisescontributionasitisrepresentedbythegapbetweenthe totalrevenueandthevariablecostlines.ThisisshownforCompanyAinFigure2. Finally,aprofitvolumegraphcouldbedrawn,whichemphasisestheimpactofvolumechangesonprofit (Figure3).ThisiskeytothePaperF5syllabusandisdiscussedinmoredetaillaterinthisarticle.

ASCERTAININGTHESALESVOLUMEREQUIREDTOACHIEVEATARGETPROFIT
Aswellasascertainingthebreakevenpoint,thereareotherroutinecalculationsthatitisjustas importanttounderstand.Forexample,abusinessmaywanttoknowhowmanyitemsitmustsellinorder toattainatargetprofit. Example1 CompanyAwantstoachieveatargetprofitof$300,000.Thesalesvolumenecessaryinordertoachieve thisprofitcanbeascertainedusinganyofthethreemethodsoutlinedabove.Iftheequationmethodis used,theprofitof$300,000isputintotheequationratherthantheprofitof$0: (50Q)(30Q)200,000=300,000 20Q200,000=300,000 20Q=500,000 Q=25,000units. Alternatively,thecontributionmethodcanbeused: UCM=20,FC=200,000andP=300,000. Q=FC+P UCM

Q=200,000+300,000 20 ThereforeQ=25,000units. Finally,theanswercanbereadfromthegraph,althoughthismethodbecomesclumsierthanthe previoustwo.Theprofitwillbe$300,000wherethegapbetweenthetotalrevenueandtotalcostlineis $300,000,sincethegaprepresentsprofit(afterthebreakevenpoint)orloss(beforethebreakeven point.) Acontributiongraphshowsthedifferencebetweenthevariablecostlineandthetotalcostlinethat representsfixedcosts.Anadvantageofthisisthatitemphasisescontributionasitisrepresentedbythe gapbetweenthetotalrevenueandvariablecostlines. Thisisnotaquickenoughmethodtouseinanexamsoitisnotrecommended. Marginofsafety Themarginofsafetyindicatesbyhowmuchsalescandecreasebeforealossoccurs,ieitistheexcessof budgetedrevenuesoverbreakevenrevenues.UsingCompanyAasanexample,letsassumethat budgetedsalesare20,000units.Themarginofsafetycanbefound,inunits,asfollows: Budgetedsalesbreakevensales=20,00010,000=10,000units. Alternatively,asisoftenthecase,itmaybecalculatedasapercentage: Budgetedsalesbreakevensales/budgetedsales. InCompanyAscase,itwillbe10,000/20,000x100=50%. Finally,itcouldbecalculatedintermsof$salesrevenueasfollows: Budgetedsalesbreakevensalesxsellingprice=10,000x$50=$500,000. Contributiontosalesratio Itisoftenusefulinsingleproductsituations,andessentialinmultiproductsituations,toascertainhow mucheach$soldactuallycontributestowardsthefixedcosts.Thiscalculationisknownasthe contributiontosalesorC/Sratio.Itisfoundinsingleproductsituationsbyeithersimplydividingthetotal contributionbythetotalsalesrevenue,orbydividingtheunitcontributionmargin(otherwiseknownas contributionperunit)bythesellingprice: ForCompanyA:$20/$50=0.4 Inmultiproductsituations,aweightedaverageC/Sratioiscalculatedbyusingtheformula: Totalcontribution/totalsalesrevenue ThisweightedaverageC/SratiocanthenbeusedtofindCVPinformationsuchasbreakevenpoint, marginofsafetyetc. Example2 Aswellasproducingproductxdescribedabove,CompanyAalsobeginsproducingproducty.The followinginformationisavailableforbothproducts:
Salesprice Variablecost Contribuionperunit Budgetedsales(units) Productx $50 $30 $20 20,000 Producty $60 $45 $15 10,000

TheweightedaverageC/Sratiocanbeonceagaincalculatedbydividingthetotalexpectedcontribution bythetotalexpectedsales: (20,000x$20)+(10,000x$15)/(20,000x$50)+(10,000x$60)=34.375% TheC/Sratioisusefulinitsownrightasittellsuswhatpercentageeach$ofsalesrevenuecontributes towardsfixedcostsitisalsoinvaluableinhelpingustoquicklycalculatethebreakevenpointin$sales revenue,orthesalesrevenuerequiredtogenerateatargetprofit.Thebreakevenpointcannowbe calculatedthiswayforCompanyA: Fixedcosts/contributiontosalesratio=$200,000/0.34375=$581,819ofsalesrevenue. Toachieveatargetprofitof$300,000: Fixedcosts+requiredprofit/contributiontosalesratio=$200,000+$300,000/0.34375=$1,454,546. Ofcourse,suchcalculationsprovideonlyestimatedinformationbecausetheyassumethatproductsxand yaresoldinaconstantmixof2xto1y.Inreality,thisconstantmixisunlikelytoexistand,attimes,more ymaybesoldthanx.Suchchangesinthemixthroughoutaperiod,eveniftheoverallmixfortheperiod is2:1,willleadtotheactualbreakevenpointbeingdifferentthananticipated.Thispointistouchedupon againlaterinthisarticle.

Contributiontosalesratioisoftenusefulinsingleproductsituations,andessentialinmultiproduct situations,toascertainhowmucheach$soldactuallycontributestowardsthefixedcosts. Table3:Figure3continued

Salesprice Variablecosr Contributionperunit Budgetedsales(units) C/Sratios WeightedaverageC/Sratio Productranking(mostprofitable first) Productx $50 $30 $20 20,000 0.4 1 0.34375 Producty $60 $45 $15 10,000 0.25 2

Product (Fixedcosts) X Y

Contribution $'000 0 400 150

Cumulative profit/loss $'000 (200) 200 350

Revenue $'000 0 1,000,000 600,000

Cumulative revenue $'000 0 1,000,000 1,600,000

Inordertodrawamultiproduct/volumegraphitisnecessarytoworkouttheC/Sratioofeachproduct beingsold.

MULTIPRODUCTPROFITVOLUMECHARTS
Whendiscussinggraphicalmethodsforestablishingthebreakevenpoint,weconsideredbreakeven chartsandcontributiongraphs.Thesecouldalsobedrawnforacompanysellingmultipleproducts,such asCompanyAinourexample.Theonetypeofgraphthathasntyetbeendiscussedisaprofitvolume graph.Thisisslightlydifferentfromtheothersinthatitfocusespurelyonshowingaprofit/losslineand doesntseparatelyshowthecostandrevenuelines.Inamultiproductenvironment,itiscommonto actuallyshowtwolinesonthegraph:onestraightline,whereaconstantmixbetweentheproductsis assumedandonebowshapedline,whereitisassumedthatthecompanysellsitsmostprofitable productfirstandthenitsnextmostprofitableproduct,andsoon.Inordertodrawthegraph,itistherefore necessarytoworkouttheC/Sratioofeachproductbeingsoldbeforerankingtheproductsinorderof profitability.ItiseasyhereforCompanyA,sinceonlytwoproductsarebeingproduced,andsoitisuseful todrawaquicktable(preventsmistakesintheexamhall)inordertoascertaineachofthepointsthat needtobeplottedonthegraphinordertoshowtheprofit/losslines.SeeTable3. Thegraphcanthenbedrawn(Figure3),showingcumulativesalesonthexaxisandcumulative profit/lossontheyaxis.Itcanbeobservedfromthegraphthat,whenthecompanysellsitsmost profitableproductfirst(x)itbreaksevenearlierthanwhenitsellsproductsinaconstantmix.Thebreak evenpointisthepointwhereeachlinecutsthexaxis.

LIMITATIONSOFCOSTVOLUMEPROFITANALYSIS
Costvolumeprofitanalysisisinvaluableindemonstratingtheeffectonanorganisationthatchangesin volume(inparticular),costsandsellingprices,haveonprofit.However,itsuseislimitedbecauseitis basedonthefollowingassumptions:Eitherasingleproductisbeingsoldor,iftherearemultiple products,thesearesoldinaconstantmix.WehaveconsideredthisaboveinFigure3andseenthatif theconstancemixassumptionchanges,sodoesthebreakevenpoint. Allothervariables,apartfromvolume,remainconstant,ievolumeistheonlyfactorthatcauses revenuesandcoststochange.Inreality,thisassumptionmaynotholdtrueas,forexample, economiesofscalemaybeachievedasvolumesincrease.Similarly,ifthereisachangeinsalesmix, revenueswillchange.Furthermore,itisoftenfoundthatifsalesvolumesaretoincrease,salesprice mustfall.Theseareonlyafewreasonswhytheassumptionmaynotholdtruetherearemanyothers. Thetotalcostandtotalrevenuefunctionsarelinear.Thisisonlylikelytoholdashortrun,restricted levelofactivity. Costscanbedividedintoacomponentthatisfixedandacomponentthatisvariable.Inreality,some costsmaybesemifixed,suchastelephonecharges,wherebytheremaybeafixedmonthlyrental chargeandavariablechargeforcallsmade. Fixedcostsremainconstantoverthe'relevantrange'levelsinactivityinwhichthebusinesshas experienceandcanthereforeperformadegreeofaccurateanalysis.Itwilleitherhaveoperatedat thoseactivitylevelsbeforeorstudiedthemcarefullysothatitcan,forexample,makeaccurate predictionsoffixedcostsinthatrange.

Profitsarecalculatedonavariablecostbasisor,ifabsorptioncostingisused,itisassumedthat productionvolumesareequaltosalesvolumes. WrittenbyamemberofthePaperF5examiningteam

Lastupdated:21Nov2013