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1.

1 COST BEHAVIOUR
Cost behavior refers to how a cost will react or
respond to changes in the level of business
activity. As the activity level rises and falls, a
particular cost may rise and fall as well or it may
remain constant.
TYPES OF COST BEHAVIOUR
VARIABLE COSTS
A variable cost is a cost that changes in total in
direct proportion to a change in the level of
activity (or cost driver). A 10% increase in the
units of production, for instance, would produce a
10% increase in variable costs. However, the
variable cost per unit remains the same as activity
changes.
Ex: direct materials, direct labour, manufacturing
overhead (such as utilities, supplies, and
lubricants) and sales commissions.
Fixed Cost
A fixed cost remains unchanged in total as the
level of activity (or cost driver) varies. It means
that they are not immediately affected by
changes in the cost driver.
• Rent or depreciation expenses for factory
building.
• Depreciation on factory machinery and
equipment.
• Insurance and property taxes on manufacturing
facilities and
• Production supervisory salaries
1.2 WHAT IS CVP ANALYSIS?
Cost-volume-profit (CVP) analysis is a technique that
examines changes in profits in response to changes in
sales volumes, costs, and prices. Accountants often
perform CVP analysis to plan future levels of
operating activity and provide information about:
• Which products or services to emphasize
• The volume of sales needed to achieve a targeted
level of profit
• The amount of revenue required to avoid losses
• Whether to increase fixed costs
• How much to budget for discretionary
expenditures
• Whether fixed costs expose the organization to an
unacceptable level of risk
1.3 Assumptions in CVP Analysis
 All costs are classified as fixed or variable with unit level activity
cost drivers.
 When graphed, the behavior of total revenues and total costs is
linear (straight-line) in relation to output units within the
relevant range.
 The unit selling price, unit variable costs, and total fixed costs
are known and constant.
 It ignores time value of money. In CVP analysis, all revenues and
costs can be added and compared without taking into account
the time value of money.
 For multiproduct companies, sales mix is constant. Sales mix is
the relative proportion of quantities of products or services that
make up total revenue.
 In manufacturing companies, inventories do not change or
beginning inventory equals ending inventory. This implies that
units produced equal units sold.
 Workers and machine efficiency and productivity will be
unchanged
1.4. CONTRIBUTION MARGIN VS GROSS MARGIN
Contribution margin can be expressed in three ways: in
total, on a per unit basis, and as percentage of revenues.
1. The total contribution margin is total revenue minus
total variable costs. Total CM7j= Total revenue – Total VC
2. The contribution margin per unit is the selling price
per unit minus the variable cost per unit.
Unit CM= Unit sales price – Unit VC
3. Contribution margin percentage (also called
contribution margin ratio or P/V ratio**) is the
percentage of contribution margin in sales.
CM ratio= Total CM/Total sales or
CM ratio= Unit CM÷ Unit Selling Price
CVP analysis begins with the basic profit equation.
• Profit = Total revenue - Total costs
• Separating costs into variable and fixed categories, we
express profit as: Profit = Total revenue - Total variable
costs - Total fixed costs Profit =P.Q-V.Q-FC
Where P=sales price per unit V=Variable cost per unit
Q=units sold
FC=Fixed cost per period
Variable cost ratio is the percentage of variable cost in sales.
Variable cost ratio is the percentage of variable cost in sales.
Variable cost ratio=
Total VC /Total sales or
Unit variable cost/Unit sales price
1.5.BREAK EVEN ANALYSIS
Break-even point (BEP) can be defined as the point where total sales
revenue equals total costs, i.e., total variable cost plus total fixed costs. It
is a point where the total contribution margin equals total fixed expenses.
Stated differently, it is a point where the operating income is zero.
There are three ways to compute the BEP
A.Equation Technique
It is the most general form of break-even analysis that may be adapted to
any conceivable cost-volume-profit situation. This approach is based on
the profit equation. Income (or profit) is equal to sales revenue minus
expenses.
Contribution Margin Technique
The contribution margin technique is merely a short version of the
equation technique. Under this method, the breakeven point (BEP) in
units and in revenues is computed as follows:
BEP units = Total fixed costs/CM per unit
BEP revenues = Total fixed costs/CM Ratio
Graphical Method
In the graphical method, the point of intersection of the total cost line
and revenue line is the breakeven point.
Example 1. Zoom Company manufactures and sells
a telephone answering machine. The company’s
income statement for the most recent year is given
below:
Based on the above data, answer the following
questions.
Required:
A.Compute the company’s CM ratio and variable
expense ratio.
B. compute the company’s break-even point in both
units and sales birrs. Use the above three
approaches to compute the break-even.
C. assume that sales increase by Br. 400,000 next
year. If cost behavior patterns remain unchanged,
by how much will the company’s net income
increase?
Method 2: Contribution Margin Method
i)BEP (in units) = Fixed expenses/CM per unit
= Br. 240,000/Br. 60 – Br. 45
= 16,000 units
ii)BEP (in birrs) = Fixed expenses/CM – ratio
= Br. 240,000/0.25
= Br. 960,000
Method 3: Grapical meth
C. Since the fixed expenses are not expected to change,
net income will increase by the entire Br. 100,000
increase in contribution margin.
Increase in sales Br. 400,000
Multiply by the CM ratio X 25%
Expected increase in contribution margin Br. 100.000
2.6.MARGIN OF SAFETY
The margin of safety is the excess of budgeted
(or actual) sales over the breakeven volume of
sales. It states the amount by which sales can
drop before losses begin to be incurred.
Margin of safety= Total sales - Break even Sales
Margin of safety ratio = Margin of safety/Total
sales
Example 2. Zumura Company manufactures and
sells a telephone answering machine. The
company’s income statement for the most recent
year is given below:
2.7. SENSITIVITY ANALYSIS
WHAT IS SENSITIVITY ANALYSIS?
Sensitivity analysis is a "what if" technique that managers
use to examine how a result will change if the original
predicted data are not achieved or if an underlying
assumption changes.
In the context of CVP analysis, sensitivity analysis
examines how operating income (or the breakeven point)
changes if the predicted data for selling price, variable
costs per unit, fixed costs, or units sold are not achieved.
The sensitivity to various possible outcomes broadens
managers' perspectives as to what might actually occur
before they make cost commitments.
Example 1 : Addis Matador Tires, Inc. sells tires to
service stations for an average of Br 450 each. The
variable cost of each tire is Br 300 and monthly fixed
manufacturing costs total Br 150,000. Other monthly
fixed costs of the company total Br 120,000.
Required:
a)What is the break-even sale of Addis?
b)What is the break-even level in tires, assuming
variable costs increase by 20 percent?
c)What is the break-even level in tires, assuming the
selling price goes up by 10 percent, fixed
manufacturing costs and other fixed costs decline by
10% and Br 1,500, respectively? Assume all other
factors remain unchanged.
Soln:
a)BEP (in units) = Fixed expenses/CM per unit
= Br 270,000/Br 450– Br 300
= 1,800 tires
BEP (in birrs) = BEP (in units) x P=1,800 x 450
= Br 810,000
b) BEP (in units) = Fixed expenses/CM per unit
= Br 270,000/450– 360
= 3,000 tires
New VC= 300 X 1.2=Br 360
c) BEP (in units) = Fixed expenses/CM per unit
= Br 253,500/495–300= 1,300 tires
New fixed cost? =Br 253,500
New sales price= 450 x 1.1=Br 495
2.8. TARGET PROFIT ANALYSIS
CVP analysis often assists in the development of detailed profit
plans by allowing management to manipulate the cost-volume
profit relationships to determine the required sales volume
needed to achieve the desired profit. The sales volume necessary
to achieve a target profit can be determined using the following
formulae:
Target sales (in units) = Total Fixed Costs+ NI**/CM per unit
Target sales (in dollars) = Total Fixed Costs+ NI/CM Ratio
**NI=Net income before taxes
Thus, the target profit indicates the level of activity or
dollar sales amount at which total contribution margin
equals total fixed costs plus the desired profit amount.
2.8 IMPACT OF TAXES ON CVP ANALYSIS

In order to determine the level of sales required to


achieve a profit level on an after-tax basis, it is
necessary to first convert the after-tax profit-to-
profit before-tax as follows:
NIBT=NIAT/1-t
*NIBT=net income before tax
T=tax rate
In this equation “t”& NIAT are the prevailing
company tax rate and net income after taxes,
respectively
Example 1. Selam Company has revenues of Br
500,000, variable costs of Br 350,000 and fixed
costs of Br 135,000.
Required:
a)Compute contribution margin percentage.
b)Compute total revenues needed to break even.
c)Compute total revenues needed to achieve a
target operating income of Br 45,000.
d)Compute total revenues needed to achieve a
target after tax net income of Br 63,000, assuming
the income tax rate is 40%.
Part II: CVP ANALYSIS AND MULTIPRODUCT
COMPANIES
*What if the company deals with several product?
Sales mix (also called revenue mix) is defined as the
relative proportions or combinations of quantities of
products that comprise total sales. If the proportions
of the mix change, the CVP relationships also change.
Thus, managers try to achieve the combination, or
mix, that will yield the greatest amount of profit.
In the general case the CVP equation could be
presented as:
P1Q1 + P2Q2+...+PnQn – V1Q1 – V2Q2-...VnQn-FC = NI
where
Pi = Selling price per unit of product i
Qi = Number units of i produced and sold
Vi = Unit variable cost of product I
FC = Fixed Cost per Period
NC = Net Income
In a multi product firm, break-even analysis is
somewhat more complex. The reason is that different
products will have different selling prices, different
costs, and different contribution margins. Using
contribution margin approach, the computation of the
break-even point (BEP) in multi product firm follows:
BEP (in units) = Total fixed expenses/*Weighted
average CM
BEP (in birrs) = Total Fixed Expenses/CM ratio
Note: *Weighted average unit contribution margin is
the average of the several products’ unit contribution
margins, weighted by the relative sales proportion of
each product
For a company with more than one product, sales
mix is the relative combination in which a
company’s products are sold.
Different products have different selling prices,
cost structures, and contribution margins.

Let’s assume ABC company sells X &Y Product and


see how we deal with break-even analysis.
How much is the BEP Units?
Summary
CVP Analysis
CVP
Assignments 1
1. ABC Printers provides photocopy services to its customers.
The unit variable cost and selling price are Br 0.20 and Br 0.50,
respectively, while monthly fixed costs total Br. 1,500.
Required:
a) How many pages must ABC copy in a month to breakeven?
b) How many pages must ABC copy to earn Br. 900 profit per
month?
c) How much sales revenue should ABC earn in a month to
breakeven?
d) How many pages must ABC copy to earn Br. 700 profit after
30% income tax?
e) If price per page is increased to Br. 75, how many pages
must ABC copy in a month to breakeven?
Assignment 2