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PAT COLLEGE

CAT P7 Accounting for cost Lecture Notes Decision Making - CVP ANALYSIS 1. Cost/Volume/Profit (CVP) or Breakeven Analysis

CVP analysis or breakeven analysis is the study of the interrelationship between costs, volume and profit at various levels of activity. To help planning and decision making, management should know, not only the profit likely to be made, if the aimed for production and sales for the year are achieved, but also: The activity level at which there is neither profit or loss (i.e. break even point) The amount by which actual sales can fall below anticipated sales, without a loss being incurred.

2.

BREAK EVEN POINT (BEP)

The BEP is the activity level at which there is neither profit nor loss. It can be calculated arithmetically as follows:

BEP in units

Total Fixed Costs Unit Contribution

or

Contribution required to break even Unit Contribution

BEP in Revenue ()
Alternatively:

BEP in units

Unit Selling Price

BEP in Revenue ()
Where:

Fixed costs or Required Contribution C / S Ratio = = Selling Price Variable cost per unit and Contribution Sales Revenue (expressed in %)

Unit Contribution C / S ratio

3.

MARGIN OF SAFETY (M.O.S.): 1

The M.O.S. is the difference in units between the budgeted sales volume and the break even sales volume and is sometimes expressed as a percentage of the budgeted sales volume.

M.O.S. in units M.O.S. in Revenue ()

= =

Budgeted Sales Volume (units) Budgeted Sales Revenue ()

BEP in Units BEP in Revenue ()

M.O.S. in units expressed in % =

Budgeted Sales Volume (units) - BEP in Units X 100 % Budgeted Sales Volume in units

M.O.S. in Revenue expressed in % = Budgeted Sales Revenue () - BEP in Revenue () X 100 % Budgeted Sales Revenue () Example 1: Expected Sales 10,000 units at 8 per unit Variable Costs: Direct Materials 3 per unit Direct Labour 1 per unit Variable Overhead 1 per unit Fixed Production Costs 21,000 Compute (i) Break even point in units and revenue (ii) Margin of safety in units and revenue Example 2: The C/S ratio of Product Alpha is 20%. AB Ltd, the manufacturer of Product Alpha, wishes to to make a contribution of 50,000 towards fixed costs. How many units of Preoduct Alpha must be sold if the selling price is 10 per unit? Example 3: Homer Ltd makes and sells a product which has a variable costs of 30 and which sells for 40. Budgeted fixed costs are 70,000 and budgeted sales are 80,000 units. Compute (i) Break even point in units and revenue (ii) Margin of safety in units and revenue 4. BREAK EVEN ARITHMETIC 2

At breakeven point, sales revenue (SR) equals total costs (TC) and there is no profit. i.e. SR S (x) S (x) Where x S F V = = = = = = = TC Fixed Costs F + + Variable Costs V (x)

the sales quantity Unit Selling Price Total Fixed Costs Unit Variable Costs

Target Profits (P): The target profit is achieved when: S (x) S (x) = = Therefore Fixed Costs F S (x) + + Variable Costs V (x) V (x) = + F + + Target Profits P P

Example: 4 Upminister Ltd makes a product, which has a variable cost of 7 per unit. Required: If fixed costs are 63,000 per annum, calculate the selling price per unit if the company wishes to break even with a sales volume of 12,000 units. Example 5: Whoopee Ltd makes and sells a single product, for which variable costs are as follows: Direct Materials 10 Direct Labour 8 Variable Production Overhead 6 24 The sales price is 30 per unit and fixed cost per annum are 68,000. The company wishes to make a profit of 16,000 per annum.

Required: Determined the sales required to achieve this profit. 3

5.

DECISIONS TO CHANGE SALES PRICE OR COSTS

You may come across a problem in which you will be expected to analyse the effect of altering the selling price, variable Cost per unit or fixed Cost. These problems are slight variations on basic breakeven arithmetic. EXAMPLE 6: CHANGE IN SELLING PRICE

Fairy Ltd bakes and sells a single type of cake. The variable Cost of production is l5p and the Current sales price is 25p. Fixed Costs are 2,600 per month, and the annual profit for the Company at current sales volume is 36,000. The volume of sales demand is constant throughout the year. The sales manager wishes to raise the sales price to 29p per cake, but considers that a price rise will result in some loss of sales. Required Ascertain the minimum volume of sales required each month to justify a rise in price to 29p. Example 7: Grumpy Ltd wishes to sell 14,000 units of its product, which has a variable cost of 15 to make and sell. Fixed costs are 47,000 and the required profit is 23,000. Required Calculate the sales price per unit. EXAMPLE 8: TARGET PROFITS Flash Ltd makes and sells three products, Bang, Crash and Wallop. The selling price per unit and costs are as follows. Bang Crash Wallop Selling price per unit 80 50 70 Variable cost per unit 50 10 20 Fixed costs per month = 160,000 The maximum sales demand per month is 2,000 units of each product and the minimum sales demand is 1,000 of each. Required (a) Comment on the potential profitability of the company. (b) Suppose that there is a fixed demand for Bangs and Crashes of 1,500 units per month,

which will not be exceeded, but for which firm orders have been received. Determine how many Wallops would have to be sold to achieve a profit of at least 25,000 per month. EXAMPLE 9 : CHANGE IN PRODUCTION COSTS Brick Ltd makes a product which has a variable production cost of 8 and a variable Sales cost of 2 per unit. Fixed costs are 40,000 per annum, the sales price per unit is 18, and the current volume of output and sales is 6,000 units. The company is considering whether to have an improved machine for production. Annual hire costs would be 10,000 and it is expected that the variable cost of production would fall to 6 per unit. Required (a) Determine the number of units that must be produced and sold to achieve the same profit as is currently earned, if the machine is hired. (b) Calculate the annual profit with the machine if output and sales remain at 6,000 units per annum. 6. BREAKEVEN CHARTS The breakeven point can also be determined graphically using a breakeven chart. A breakeven chart is a chart, which shows approximate levels of profit or loss at different sales volume levels within a limited range.

A breakeven chart has the following axes: A horizontal axis showing the sales/output (in value or units). A vertical axis showing for sales revenues and costs

The following lines are drawn on the break-even chart: The sales line: - Starts at the origin - Ends at the point signifying expected sales The fixed costs line: - Runs parallel to the horizontal axis - Meets the vertical axis at a point which represents total fixed costs The total costs line: - Starts where the fixed costs line meets the vertical axis - Ends at the point which represents the following: Anticipated sales on the horizontal axis Total costs of anticipated sales on the vertical axis 5

The breakeven point is the intersection of the sales line and the total costs line. The distance between the breakeven point and the expected (or budgeted) sales, in units, indicates the margin of safety.

EXAMPLE 10: A BREAKEVEN CHART The budgeted annual output of a factory is 120,000 units. The fixed overheads amount to 40,000 and the variable costs are 50p per unit. The sales price is 1 per unit. Required Construct a breakeven chart showing the current breakeven point and profit earned up to the present maximum capacity. 6.1 THE VALUE OF BREAKEVEN CHARTS

Breakeven charts are used as follows: 6.2 To plan the production of a companys product To market a companys products To give a visual display of break even analysis PROFIT VOLUME CHARTS

The profit volume (P/V) chart is a variation of the breakeven chart which provides a simple illustration of the interrelationship of costs and profits to sales. Example 11: Use the information in example 10 above to draw a P/V chart. 6.3 THE ADVANTAGES AND LIMITATIONS OF CVP ANALYSIS

Limitations of CVP analysis A breakeven chart can only apply to one single product or a single mix (fixed proportions) of a group of products. It is assumed that fixed costs are the same in total and variable costs are the same per unit at all levels of output. This is a simplification.

- Fixed costs will change if output falls or increases substantially - most fixed costs are step costs - The variable cost per unit will decrease where economies of scale are made at higher output volumes, and the variable cost per unit will also eventually rise where diseconomies of scale begin to appear at higher volumes of output (for example the extra cost of labour in overtime working). 6

A breakeven chart is drawn on the assumption that fixed costs and the variable cost per unit is constant, this is only correct within the relevant range of output. It is assumed that sales prices will be constant at all levels of activity. This may not be true, especially at higher volumes of output, where the price may have to be reduced to win the extra sales. Production and sales are assumed to be the same, therefore the consequences of any increase in stock levels (when production volumes exceed sales) or 'de-stocking' (when sales volumes exceed production levels) are ignored. Uncertainty in the estimates of fixed costs and unit variable costs is often ignored in breakeven analysis, and some costs (for example mixed costs and step costs) are not always easily categorized or divided into fixed and variable.

The advantages of CVP analysis In spite of limitations, breakeven analysis is a useful technique for managers in planning sales prices, the desired sales mix, and profitability. Breakeven analysis should be used with a full awareness of its limitations, but can usefully be applied to provide simple and quick estimates of breakeven volumes or profitability given variations in sales price, variable and fixed costs within a 'relevant range' of output/sales volumes.