University of London (LSE)

(UOL AC2097) Management Accounting

(2020 Academic Year)

Ms Joanna Chia

Session 3 Lecture Notes

Cost-Volume-Profit /
Break-even Analysis

For SIM Students’ Use Only

Do not distribute or upload to websites or reproduce in any form.
Not to be reproduced for sale.

DEFECTS ARE INHERENT IN THE ORIGINAL COPY

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 Session 3

Cost-Volume-Profit Analysis

3.1 Cost-Volume-Profit (CVP)

CVP analysis can be used to ‘help a firm execute its strategy by providing an
understanding of how changes in its volume of sales affect costs and profits.’ (Blocher et
al 2010, p.327) It can be applied to determine the sensitivity of profits to possible
changes in costs or sales volume. The sensitivity analysis or “What-if” analysis is used to
‘examine how an amount of changes to factors involved in predicting that amount
change. (Blocher et al 2010, p.338)

Horngren et al (2015, p. 89) defines cost-volume-profit (CVP) analysis as the study of

the behaviour and relationship of total revenues, total costs, and income as changes
occur in the units sold, the selling price, variable cost per unit, or the fixed costs of a
product. It ‘is a method for analyzing how various operating decisions and marketing
decisions will affect profit.’ (Blocher, Stout & Cokins 2010, p. 325)

It focuses on four key variables - Costs, Revenues, Volume of Output, and Profits and
looks at the changes in profits arising from changes in the volume of output, variable
costs or fixed costs

Cost-volume-profit or Breakeven analysis is a guide to develop short term strategies.

According to Blocher et al (2010, pp. 325-6), CVP is used in many applications, such as:
• Setting prices for products and services
• Introducing a new product or service
• Replacing a piece of equipment
• Determining the breakeven point
• Deciding whether to make or buy a given product or service
• Determining the best product mix
• Performing strategic what-if analyses

3.2 Contribution Margin (CM)

Contribution Margin is the difference between total revenues and total variable costs. It
indicates why profit changes as the sales volume or units sold changes.

Contribution Margin = Total Revenues less Total Variable Costs

Contribution margin per unit is a useful tool used to compute the contribution margin and
operating income. (Horngren et al 2015)

Contribution Margin Per Unit = Selling Price less Variable Cost per unit

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3.3 Profit, Loss, Breakeven

At given output level,

If CM > Fixed Costs (FC) → it results in a Net Profit

If CM < Fixed Costs (FC) → it results in a Net Loss
If CM = Fixed Costs (FC) → it results in a Break-even (No Profit or loss)

The Break-even point (BEP) ‘is that quantity of output sold at which total revenues equal
total costs, that is, the quantity of output sold that results in $0 of operating income.’
(Horngren et al 2015, p. 95)

3.4 Assumptions used in CVP or Breakeven Analysis

• Changes in revenue levels and costs arise due to changes in volume of units sold
• Total costs can be separated into a fixed component that does not vary with the
output level and a component that is variable to the output level.
• Variable costs vary linearly with output within a relevant range and time period.
• The selling price, variable cost per unit, and fixed costs are known and constant.
• Assumes a single product or a constant sales mix when multiple products are sold as
the level of total units sold changes.
• Time value of money is not considered in the analysis.

3.5 Special Cases that may not go with the CVP assumptions:
(i) If fixed costs are actually stepped fixed costs, it would be possible to have more
than one break-even point.

(ii) Direct labour is one variable cost that might change in direct proportion to
volume. There might be a learning situation in which case the costs would not be
constant

(iii) Or there may be learning effect but overtime is paid at a premium causing an
increase in costs

(iv) Volume may not be the only factor affecting cost. It may be the case government
action that will affect cost. For example, the government might raise taxes on
inputs and hence raise total costs. This will of course raise the break-even point.

(v) The economist would argue against the assumption, that linearity is not
appropriate by saying that the law of diminishing returns would have following
implications:

Other possible situations:

I. To sell more units, prices have to be reduced;

II. To buy more raw materials, more has to be paid because they are in scarce supply.

Generally Break-even chart shows the relationship between total cost and total revenue
at different output levels.

CVP chart shows profit levels at each level of output and break even output occurs
where the profit line cuts the output axis.

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3.6 Formulae:

1) Contribution per unit = Sales per unit less Variable Costs per unit

2) Break-even point (in units) = Fixed costs .

Contribution per unit (ie. Sales – Variable costs)

Or alternatively, use the equation method:

Sales revenue – Variable costs – Fixed costs = $0 Operating profit
(USP X Q) - (UVC X Q) - FC = $0
Find Q (number of units)

3) Break-even point (in sales values $) = Fixed costs____________.

Contribution/Sales ratio or C/S Ratio

Or Break-even point (in units) x Unit Selling Price

4) Contribution/Sales (C/S) Ratio = CM Ratio (Contribution Margin Ratio) or P/V

Ratio (Profit Volume Ratio)

= Total Contribution or Contribution per unit

Total Sales Revenue Sales price per unit

The C/S or P/V ratio is a measure of the rate at which profit is generated with
sales volume, comparable to the gross profit margin

5) Sales (in units) required to obtain required profit (before tax)

= Fixed costs + Targeted Profits
Contribution per unit

6) Sales (in sales values $) required to obtain required profit

= Fixed costs + Targeted Profits
Contribution/Sales ratio

7) Sales (in units) required to obtain required profit (after tax)

= Fixed costs + (Targeted Profits/ After tax rate)
Contribution per unit

8) Sales (in sales values $) required to obtain required profit

= Fixed costs + Targeted Profits/ After tax rate)
Contribution/Sales ratio

9) Required Selling Price

= Fixed Cost + Targeted Profit + Variable Cost
Units

10) Margin of Safety (in $)= Sales (in $)– Break-even Point (in $)

11) Margin of Safety (in units)= Sales units – Break-even Point (in units)

12) Margin of Safety % = Sales – Break-even Point x 100

Sales

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 CVP Example:

JOSE Ltd

Selling Price ( $ ) 5
Fixed costs per annum ( $ ) 30,000

Semi-variable costs:
Fixed element ( $ ) 10,000
Variable element ( $ per unit ) 1
Variable costs ( $ per unit ) 2
Relevant range of output ( units ) 6,000-24,000

(i) What is JOSE Ltd’s break-even point in units?

For profit to equal zero: Break-even point = Fixed Costs / Contribution margin per unit

Break-even point (units) = $40,000 /$ 2 = 20,000 units

Or alternatively, use the equation method:

Sales revenue – Variable costs – Fixed costs = $0 Operating profit
(USP $5 X Q) - (UVC $(1+2) X Q) - FC $(30,000+10,000) = $0
5Q - 3Q – 40,000 = 0
2Q = 40,000
Q = 40,000 / 2 = 20,000 units

(ii) What is JOSE Ltd’s break-even point in sales revenue?

Break-even point in sales revenue = Break-even point (units) x Selling price

= 20,000 x $5 = $100,000

Or Break-even point in sales revenue = Fixed Costs / (C/S ratio)

= $40,000 / ($2/$5)
= $100,000

(iii) How may units must JOSE Ltd sell to obtain a targeted profit before tax of $5,000?

To cover fixed costs and generate profit before tax:

Level of required sales = (Fixed cost + Targeted profit before tax) / Contribution margin
per unit
= ($40,000 + $5,000) / $2
= 22,500 units

(iv) How may units must JOSE Ltd sell to obtain a targeted profit after tax of $5,000?
Assume a tax rate of 20%.

Level of required sales = (Fixed cost + Targeted profit after tax/After tax rate (1-tax rate)
Contribution margin per unit
= ($40,000 + ($5,000/(1-0.2) / $2
= 23,125 units

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(v) What is the level of sales revenue which results in a profit before tax of $5,000?

Level of required sales (in Sales revenue) = Level of sales (in units) x Selling price per unit
= 22,500 x $5 (SP)
= $112,500
Or (Fixed cost + Required profit) / C/S Ratio
= ($40,000 + $5,000) / ($2/$5)
= $112,500

(vi) What is the level of sales revenue which results in a profit after tax of $5,000?
Assume a tax rate of 20%.

Level of required sales (in Sales revenue) = Level of sales (in units) x Unit selling price
= 23,125 units x $5 (SP)
= $115,625
Or (Fixed cost + Required profit after tax/after tax rate)/ C/S Ratio
= ($40,000 + $5,000/1-0.2) / ($2/$5)
= $115,625

Profit-Volume Graph / Chart

Profit

Margin of safety $12,500

$5,000

$ 112,500

0 units or sales revenue

Loss BEP($100,000)

-$40,000

3.8 Margin of Safety

The margin of safety is the excess of actual or budgeted sales over the breakeven
volume. It is amount by which sales can fall before losses are incurred. It measures the
risk of not breaking even and incurring a loss. It can be expressed in units or sales
revenue or in relative terms, it is the excess of budgeted or actual sales revenue(dollars)
over the break-even volume of sales revenue and the formula is as follows:

Margin of Safety = SR - BESR

where SR is the actual or budgeted sales revenue and BESR is the Break-even sales
revenue.

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The Margin of Safety Percentage is the excess of actual or budgeted sales over the
breakeven volume expressed as a percentage of actual or budgeted sales volume.
When the margin of safety is divided by the actual(or budgeted) sales volume ( or
amount), the margin of safety ratio or % (M/S ratio) is obtained.
Margin of Safety ratio (%) = (SR – BESR) / SR x 100.

The amount of profit can be directly determined with reference to the margin of safety
and the C/S ratio. The formulae are:
Profit = (Margin of safety in $) x P / V ratio or (Margin of safety in units) x CM per unit).
3.9 Break-even Chart

Sales Revenue

Total cost

Profit

Sales & Variable cost

costs ($)

Loss Fixed cost

Margin of
safety

0 BE Point Sales Units or volume

3.10 Multi-product Cost-Volume-Profit Analysis

Most organisations sell more than one product or services so CVP analysis must adapt
to multi-product setting. There are common fixed costs that cannot be accurately
allocated to the individual types of products or services (most common fixed costs
allocation are arbitrary). These common fixed costs cannot be specifically identified so
working out the breakeven point of each product or service using the allocated fixed
costs divided by the unit contribution margin should not be done. In such cases, the
breakeven point should be calculated based on an expected sales mix. Note that the
breakeven point changes when the sales mix change.

A ‘sales mix is the quantities (or proportion) of various products (or services)that
constitute a company’s total units sales’ (Horngren et al 2015, p. 106). For example: If
the company sells 100 units of product A and 400 units of product B, the sales mix is
20% [100/(100+400)] of A and 80% (400/500) of B.

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The sales mix is an important assumption in multiproduct CVP analysis as it is used to
calculate the weighted average unit contribution margin.

The break-even point formula for multiple products is:

Break-even point = Fixed costs / Weighted average unit contribution margin
This answer must be broken up in the proportion of the expected sales mix.

Multi-product CVP Example:

Joseph Ltd manufactures and sell two products: A and B.

A B Total
Units sold 100 400 500
Unit selling price $80 $100
Unit variable cost 50 80
Total fixed costs 4,400

Solution:

Sales mix: A = 100/500 units = 20%

B = 400/500 units = 80%

A B Total
Unit selling price $80 $100
Unit variable cost 50 80
Contribution 30 20
Sales mix 20% 80%
Weighted average contribution $6 $16 $22

Break-even point = Fixed costs / Weighted average unit contribution margin

= $4,400 / $22
= 200 units
Break-even point of Product A = 200 units x sales mix 20% = 40 units
Product B = 200 units x sales mix 80% =160 units

3.11 Operating Leverage

Operating leverage or the degree of operating leverage is a ‘measure of the sensitivity of

profits in relation to fluctuations in sales’(Drury 2015, p. 190). It measures the effects of
fixed costs on profits (operating income) as changes occur in units sold, and to total
contribution margin. It measures the risk-return trade-off across alternative cost
structures.

A high proportion of fixed costs in an organisation results in high operating leverage. It

will then have to sell more in order to cover the fixed costs. Small increases in sales lead
to large increase in operating incomes and small decreases in sales result in relatively
large decreases in operating incomes leading to a greater risk of operating losses.

Knowing the degree of operating leverage at a given level of sales helps managers
calculate the effect of fluctuations in sales on profits. It measures the percentage impact
on profit of a given percentage change in sales revenue.

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Formula:

Degree of Operating Leverage = Contribution Margin / Profit (Operating income)

Note : Operating Income is defined as total revenues from operations less cost of goods
sold and operating costs excluding interest expense and taxes. (PBIT)

Example :

Product X, Selling price = $10 per unit, Variable cost per unit = $4 and Fixed cost per
year = $500.

Units Sold 100 units 200 units

Sales 1,000 2,000
Less : Variable Costs 400 800
Contribution 600 1,200
Fixed Costs 500 500
Profit 100 700

Degree of = Contribution / Profit

Operating Leverage = 600/100 1,200/700
= 6 = 1.71

It means that for every 1 % change in sales, the profit will change by 6%.
The contribution margin increase by 100% (from $600 to $1,200) due to increases in
units sold but profit increases by 600% (6 x 100% increase in sales) from $100 to $700.

The higher the degree of operating leverage, the more volatile the profit relative to a
change in sales, all others remaining the same.

The degree of operating leverage will decrease as the level of sales increases beyond
the breakeven point whenever there are fixed costs. So if there are no fixed costs, the
degree of operating leverage will be one (1) at all sales levels.

3.12 Advantages of using Breakeven Analysis :

(i) it examines the inter-relationship between selling prices, sales and production
volume, costs, expenses and profits which provides useful information for
decision making and is easily understood by non-financial managers.

(ii) enables the firm to determine the sales (in units or dollars) necessary to attain a
desired level of profit
(iii) useful in assessing effect of operating changes such as changes in selling price
or operating costs upon profit.
(iv) Used in the setting of selling prices, selecting mix of products to sell, accepting
special orders, choosing among alternative marketing strategies and analysing
the effects of cost increases or decreases on the profitability of an enterprise.

(v) the contribution to the sales ratio can indicate relative profitability for different
products;
Highlights the breakeven point and the margin of safety gives managers an indication of
the risk involved, and is an aid to production and sales.

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3.13 Limitations of Break Even Analysis

(i) The Break-even concept is based on linearity concept where the product’s cost
behaviour is held constant over the relevant change. The fixed cost is held
constant within the relevant range while the variable cost and selling price per
unit are held constant. Fixed costs are fixed only within given time span and over
a relevant range, they are not constant as assumed in the break-even analysis.
(ii) Not all costs can be easily resolved into fixed and variable elements.
(iii) Variable costs are not always constant.
(iv) Productivity and efficiency do change and would affect costs.
(v) Volume is not the only factor affecting costs.
(vi) It is based on a single product mix. In other words, the concept can be easily
applied to a product with a range but not to different products which might have
different cost behaviour.
(vii)It is applicable for short-term decision making only. In the long run, no cost is
fixed. All of them become variable or semi-variable.

3.14 Curvilinear CVP Relationships

Linear CVP relationships are assumed and applied in CVP analysis for short run
decisions but it is not realistic in the real world. Curvilinear relationships of
revenue and costs are more likely.

The sales quantities can be increased by reducing selling price, but total revenue
does not increase proportionately with output, but total revenue line rise less
steeply and eventually decline. The reason for the decline is due to the adverse
effect of price reduction that outweighs the benefits of increased sales volume.
(Drury 2015, p. 173)

Total costs may increase steeply due to the lower volume as it is difficult to
efficiently utilise the full capacity of the manufacturing facilities that are designed
for much larger volume levels. However, if the firm take advantage of economies
of scale by producing more, then the total cost line will begin to level out and rise
less steeply as the firm is now able to operate the manufacturing facilities within
the efficient operating ranges to benefit from the economies of scale. This is
described as the increasing returns to scale. Costs may rise more steeply as unit
costs increase due to manufacturing facilities being operated beyond their
capacity. Machine breakdowns, bottlenecks, poor production scheduling may
cause higher unit costs and cause total costs to rise steeply. This is described as
decreasing returns to scale by economists (Drury 2015, pp.173-174).

In such instances, the total revenue and total costs may cross at two points and
will result in two breakeven points. Refer to Drury 2015, pp. 173-174.

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QUESTIONS

Question 1

The Arawak Manufacturing Company makes PSC 1. As part of its planning and
budgeting cycle, it has produced the following estimates of revenues and costs.

$ Per Unit
Selling Price 30.00

Unit Manufacturing Cost 19.50

Sales Commission 1.50

Total VC 21.00

Annual Fixed Cost $

Rent 60,000
Wages 200,000
Advertising 80,000
Other F.C 20,000
360,000

Required
(a) Calculate the annual breakeven point in
(i) units sold
(ii) revenue (4 marks)

(b) If 35,000 units are sold, what will be the operating profit/ loss? (4 marks)

(c) If the factory manager were paid an additional $0.30 per unit sold, over and
above the break-even point, what would be the operating profit if 50,000 units
were sold? (4 marks)

(d) Of what use is the above information to management? What are the limitations of
breakeven analysis? (13 marks)
[2000/ Zone B/ Q5]

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Question 2

JL plc retails two products: X and Y. The budgeted income statement for next
period is as follows:
X Y Total
Units sold 750 250 1,000
Sales revenues per unit £100 $150
Variable costs per unit 70 90
Fixed costs 6,000

Required:
(a) Calculate the total contribution and the profit.
(b) Calculate the breakeven point in units and in revenue, assuming that the
planned sales mix is attained.
(c) Calculate the breakeven point in units (a) if only X are sold and
(b) if only Y are sold.
(d) Suppose 2,000 units are sold but only 20 are X. Compute the profits and
also the breakeven points in units. Compare your answers to answers in
(b). What is the major lesson of this problem?

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Question 3

Comfort Ltd manufactures a range of high quality shoes. Although different styles and
sizes are made, the company finds it easiest to work on average costs and revenues per
pair of shoes. They have estimated their revenue and cost relationships for the
forthcoming year as follows:
Unit variable data Per Pair
Selling Price £90.00
Variable materials cost £19.00
Variable skilled labour costs £20.00
Variable other production costs £19.50
Sales staff’s commissions £4.50

Annual fixed costs Per Year

Production fixed costs 300,000
Advertising 120,000
Other fixed costs 360,000
Sales Staff’s salaries 300,000
Total fixed costs 1,080,000

The company wishes to make a profit of £600,000 for the year. The demand forecast is
vague but the company feels certain it can sell 45,000 pairs of shoes at the current price
and perhaps as many as 80,000 pairs of shoes.

Partly due to changing employment practices in the companies with whom Comfort Ltd
competes for labour, the company is exploring new pay structures which would provide
employees with greater financial security.

The company is considering the following alternatives related to two categories of

employees:
a. Currently, sales staff receive a fixed salary plus sales commission of 5% on sales.
Sales commissions could be discontinued and sales staff’s salaries would be increased
by a total of £270,000.
b. The skilled production labour is currently a variable costs averaging £20 per pair of
shoes. The company is considering paying a guaranteed wage of £1,100,000 per year in
total to its skilled production staff. The output which they would be required to achieve
before earning production bonuses would be 55,000 shoes per year. The production
bonus would be £15 for each pair over 55,000 pairs per year.

Required:
(a) For: (1) the existing payment (2) the new payment method, calculate:
(i) The break-even point,
(ii) The sales units required to achieve the target profit,
(iii) Profit at 45,000 units of sales
(iv) Profit at 80,000 units of sales
(16 marks)
(b) Make recommendations to the board concerning the alternatives. (4 marks)
(c) If the company chooses the new method of payment, should it consider producing at
least 55,000 pairs of shoes to keep the production employees busy. It could reduce the
price of any shoes not sold to £45 by having an end of year sale (at which they are all be
expected to be sold). Provide calculations and an explanation. (5 marks)
[2004/ Zone B/ Q4]

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Question 4

(UOL 2005 ZB / Q3)

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Bhimani et al. (2019) Textbook Questions:
Chapter 8, questions 8.3–8.9, 8.11 and 8.26.

Readings:

UOL AC2097 Management Accounting 2019 Subject Guide: Chapter 6 and Chapter 7,
pages 78-85.
Bhimani et al. (2019) Textbook, Chapter 8, pages 216-235.

References:

Blocher, E.J., Stout, D.E. & Cokins, G. 2010, Cost Management: A Strategic Emphasis,
5th Edn., New York, USA: McGraw-Hill.

Drury, C., 2015, Management and Cost Accounting, 9th Edn, Cengage Learning EMEA,
UK.

Horngren, C. T., Datar S. M. & Rajan M. V. 2015, Cost Accounting: A Managerial

Emphasis 15th Edn. Pearson Education Ltd. England.

Nayak, A. & Mongiello M. 2019, AC2097 Management Accounting, UOL Subject Guide,
University of London International Programmes, Publications Office, UK.

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