CHAPTER 1: Decision-making based on price setting and capacity utilisation

CHAPTER 1

LEARNING UNIT 5: Cost-Volume-Profit analysis (CVP)

ASSESSMENT CRITERIA
After working through this study unit, you should be able to
• discuss the assumptions underlying the cost-volume-profit (CVP) model
• define contribution margin and calculate the contribution margin and contribution margin ratio
• define breakeven and calculate the breakeven point in volume as well as value
• perform a sensitivity analysis to show how a change in any one variable can affect breakeven
and decision-making
• define and calculate the margin of safety
• calculate the sales volume required to achieve the target profit.

You should spend approximately 7-8 hours on mastering the learning outcomes of this Learning Unit.

5.1 INTRODUCTION

In the previous learning units, our focus was on production costs, their classification and more
specifically cost behaviour and methods of separating mixed costs into their fixed and variable
components. For purposes of the latter, we explored three methods, based on the linear cost function,
used for purposes of planning and budgeting and we explored how changes in volume (independent
variable) drive changes in costs (dependent variable).
By now you should be quite familiar with the concepts and terminology introduced in Learning Unit 2. In
this learning unit, new terms and concepts will be introduced as we continue to look at cost and volume,
but add profit prediction; i.e., our focus will be on Cost-Volume-Profit analysis for purposes of planning.
You will recall that, in carrying out their planning and decision-making responsibilities, management
would, among others, identify possible alternative courses of action and then collect relevant
information about the consequences of each alternative. Cost-volume-profit (CVP) analysis is one
technique that allows management to consider the consequences of particular courses of action. CVP-
analysis can provide answers to questions like: How many units must we sell before we start making
a profit? How many units must we sell to achieve out desired profit?

5.2 COST-VOLUME-PROFIT ANALYSIS (CVP)

A CVP analysis can help managers to make decisions such as what products to manufacture, what
prices to charge and what cost structure to maintain. The main purpose of the analysis is to estimate
how profits will be affected by selling prices, sales volumes, variable cost per unit and total fixed cost.
In a CVP-analysis, profit means the contribution margin rather than the net profit (see explanation
later). CVP analysis primarily looks at what effect different levels of output will ultimately have on the
profit of the organisation and it helps management with short-term planning and decision-making.

5.2.1 Assumptions of CVP analysis

In performing a CVP analysis, accountants make the following assumptions:

• All costs, manufacturing, administrative as well as marketing and selling costs are considered and
can be separated into either fixed costs or variable costs. *
• All the units that are manufactured are sold, i.e., all product costs are expired costs.
• The analysis is always made within the relevant range. You will recall that the relevant range refers
to the upper and lower levels of an output level within which the organisation normally operates.
• Variable costs are constant per unit and fixed costs are constant in total, therefore volume
(changes in output) affects variable costs only and the total cost will be represented by a straight
line in a graph.
• Since both costs and sales are linear, we can use the linear cost function y = a + bx to find the
values of unknown variables. *
• CVP analysis applies to short-term planning only.

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• Where more than one product is manufactured and sold, the sales mix (i.e., how many of each
product are sold) is constant (this falls beyond the scope of this module).
* Look again at Figures 2.2 and 2.3 in Learning Unit 2: the behaviour of both total fixed costs and variable
costs is represented by a straight line; hence the assumptions that all costs are linear and either fixed or
variable.
Two of the above assumptions are extremely important:
1. that all manufactured units are sold, i.e., there is no inventory and all product costs are expired costs
that have been expensed as cost of sales, and
2. that also period costs (marketing and administration costs) are included in the calculations. This is
so because profit = sales – cost of sales – period cost.
We have mentioned above that a CVP-analysis assumes that selling price per unit will be constant and
that variable cost per unit will be constant. We know that the fixed cost per unit is not constant: if total
fixed cost is R10 000, then at a volume of 10 000 units, the fixed cost per unit will be R1, but at a volume
of 5 000 units, the fixed cost per unit will be R2. Therefore, it is clear that the profit per unit (under
absorption costing) will not be constant. That is why, in a CVP-analysis, we use the contribution margin
per unit, rather than the profit per unit.
Despite the limitations of the CVP assumptions, it is a valuable tool for short-term decision-making and
profit forecasting.

ACTIVITY 5.1

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 CVP analysis cannot be used if costs cannot be separated into fixed and variable costs.
1.2 In CVP analysis, volume is always stated in units manufactured and sold.

5.2.2 Contribution margin value and ratio

Contribution margin value

The contribution margin is an important concept in CVP analysis. It means the amount of sales revenue
that is left after all variable costs (also variable period costs) have been subtracted, in other words, the
amount that will be available to cover total fixed costs. Any revenue left after fixed costs are covered,
is the profit. We could say the contribution margin ‘contributes’ to covering fixed costs.
In a CVP analysis, the contribution margin or contribution margin ratio (see further on) can be
presented for the organisation as a whole, a product line, or single unit of a single product. The
contribution margin is the difference between sales revenue and variable expenses, i.e.:
total contribution = total sales revenue – total variable expenses
For example, if the sales revenue of a company for the year is R800 000 and total variable costs are
R320 000, then the contribution margin is R480 000, from which fixed costs must be covered to make
a final profit. If the company sold 80 000 units, it means that the selling price per unit was R10 and the
variable cost per unit was R4 (R320 000 / R800 000 = 40%), leaving a contribution margin of R6 per
unit. The contribution margin helps organisations determine if they must reduce their variable costs or
increase the selling price per unit for the period considered in order to cover fixed costs or to be more
profitable.

Contribution margin ratio

Instead of stating the contribution margin in R-value as above, it can be stated as a ratio, which is
usually expressed as a percentage, i.e.:
contribution ratio = contribution margin ÷ sales
If sales revenue is R800 000 and the contribution margin is R480 000, then the contribution margin
ratio is R480 000 / R800 000 = 0,6 or 60% (or R6/R10 = 60%). The contribution margin ratio indicates

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the percentage of sales available to cover fixed costs. Profit is made only after all fixed costs are
covered.
Salaries, a fixed cost, is one of the largest cost items (if not the largest) in an organisation. You will
therefore appreciate that, for most organisations, fixed costs will be substantial. (Only manufacturing
salaries and wages are recovered through the cost of production.)

Income statement
While financial accountants focus on the preparation of information and reports in compliance with
legislation and accounting standards, management accountants are concerned with providing relevant
information to management. In management accounting and specifically this section on CVP analysis,
we shall not necessarily refer to the Statement of Comprehensive Income, but rather just say income
statement or profit statement or contribution income statement. The format of and terminology in our
income/profit statement are also customised to suit the circumstances and may very well differ from
the prescribed formats and terms used in financial accounting.

Example 5.1
The following information is available for product Q:

Units sold 5 000

R
Sales 150 000
Variable costs 45 000
Fixed costs 60 000
The total contribution and contribution per unit will be:
Total for
5 000 units Per unit
R R
Sales 150 000 30 150 000 / 5 000
Less: Variable costs 45 000 9 45 000 / 5 000
Total contribution 105 000 21 105 000 / 5 000
Contribution per unit can also be calculated as follows:
Total Contribution ÷ Total Units
R105 000 / 5 000 = R21
The contribution ratio will be: Contribution ratio = contribution / sales
Working with totals: R105 000 / R150 000 = 0,7 = 70%
Working with units: R21 / R30 = 0,7 = 70%
________________________________________________________________________________

There are times when you may be provided with the calculated values and ratios and be required to
determine another variable.

Example 5.2
The contribution margin and contribution margin ratio of a company are R30 000 and 40% respectively.
Selling price per unit is R50. Now calculate the number of units sold.
We know that contribution ratio = contribution margin ÷ sales. By applying algebra, we can find total
sales:
0,4 = R30 000 / sales
0,4 × sales = R30 000
sales = 30 000 / 0,4 = R75 000
The selling price is R50 per unit, thus R75 000 ÷ R50 = 1 500 units were sold.
________________________________________________________________________________

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Note: the contribution ratio of 40% indicates that R0,40 of every R1 of sales is available to cover fixed
costs and contribute to profit.

ACTIVITY 5.2

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 The contribution margin is the difference between total revenue and fixed costs.
1.2 The larger the contribution margin ratio, the lower the sales that are required to cover fixed
expenses.
1.3 The contribution margin per unit is equal to the difference between the selling price per unit and
the variable cost per unit.
1.4 In a profit-making company, a decrease in the selling price per unit will reduce the contribution
margin further than a 10% increase in the variable cost per unit would.

5.3 BREAKEVEN ANALYSIS

CVP analysis is useful in providing accountants with the information needed to determine the
breakeven point for short-term planning of sales targets, production budgets, profit objectives and even
pricing strategy. Breakeven is that point at which the entity makes neither a profit nor a loss, i.e., where
total fixed costs are equal to the total contribution and there is nothing left for a profit. Profits are made
only when the total contribution exceeds the total fixed costs.
There are three methods of calculating the breakeven point: the equation method, the contribution margin
method and the graph method. At the outset we wish to stress that your calculations will seldom end with
a whole number; there will almost always be a decimal. Obviously, when we calculate the number of units
to be sold, we are talking about whole units, so you will have to round your answer to a whole number.
Rounding in breakeven calculations is always up, regardless of the value of the decimal; even if the
decimal is below 0,5, e.g., 794,01 will be rounded to 795 units. More about this later.

5.3.1 Equation method for determining breakeven

You should know how profit is calculated, so you really should not have a problem in remembering
these equations:
total sales revenue 1 – total variable costs 2 – total fixed costs (TFC) = profit (P) =
1 total sales revenue = total quantity (Q *) × selling price per unit (SPU)
2 total variable costs = total quantity (Q *) × variable costs per unit (VCU)
An expanded equation for net profit would then be (Q × SPU) – (Q × VCU) – TFC = P
* Remember that CVP is based on the assumption that all units manufactured are sold; there is
therefore only one quantity, Q. Also remember that all costs (product costs and period costs) are taken
into account.
Breakeven is the point where profit is zero, thus P = 0. Assume that the SPU is R79, VCU is R39 and
TFC is R40 000.
(Q × SPU) – (Q × VCU) – TFC = P
(Q × 79) – (Q × 39) – 40 000 = 0
40Q – 40 000 = 0
40Q = 40 000
Q = 1 000, i.e., breakeven occurs where 1 000 units are manufactured and sold.
We can test this:
Sales (1 000 units × R79) R79 000
less: Variable costs (1 000 units × 39 R39 000
Contribution R40 000
Fixed costs R40 000
Net profit 0

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Breakeven in R-value is determined by multiplying the breakeven units by the selling price per unit:
1 000 × R79 = R79 000.

5.3.2 Contribution margin method for determining breakeven

This method uses an equation that is derived from the above equation. The focus is on the contribution
margin. We know that the contribution margin is total revenue less total variable costs. The contribution
margin can also be stated per unit; the contribution margin per unit (CMU) is the selling price per unit
(SPU) less the variable costs per unit (VCU). Hence, the previous equation can be restated as follows:
(Q × SPU) – (Q × VCU) – TFC = P
Q (SPU – VCU) – TFC = P
Q (CMU) * = P + TFC
Q = (P+TFC)/CMU
* SPU – VCU = CMU
We want to determine the breakeven quantity of units that must be manufactured and sold, i.e., where
P = 0, therefore Q = (0+TFC)/CMU i.e., Q = TFC/CMU. The equation to determine the breakeven point
according to the contribution margin method is therefore:
Breakeven quantity = total fixed costs / contribution margin per unit
This is an important equation and you should memorise it. Assume that the selling price per unit is R79
and variable expenses per unit R39; then the contribution margin is R40 per unit. With total fixed costs
at R40 000, breakeven quantity is calculated as follows:
Breakeven quantity = total fixed costs / contribution margin per unit
Breakeven quantity = 40 000 / 40 = 1 000 units.

5.3.3 Graph method for determining breakeven

You are already familiar with the graphic presentation of a straight line where the R-value of total costs
(the dependent variable) is shown on the y-axis and the output level (the independent variable) on the
x-axis. In finding the breakeven point according to this method, another straight line will be added to
the same graph, depicting total sales income on the y-axis and total units sold on the x-axis. The units
sold will be the same as the units manufactured, as assumed under CVP. Breakeven is where the total
income line intersects with the total costs line; breakeven in units is read on the x-axis and breakeven
in value is read on the y-axis. Below the intersection point (where the total income line lies below the
total costs line) the entity makes a loss; above the intersection (where the total income line lies above
the total costs line) the entity makes a profit. See Figure 5.1 below. The gap between the total revenue
line and the variable costs line represents the contribution margin at the different levels of output. The
arrow indicates the contribution margin at an output level of 2 500 units.

The breakeven point is indicated by the circle, where the total revenue line intersects with the total costs
line. At this point, breakeven units are 1 000 and breakeven value is R80 000. Above the breakeven
point, the gap between total revenue and total cost represents profit; below this point, the gap indicates
a loss. The gap between the variable costs line and the total costs line represents fixed costs.

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FIGURE 5.1: BREAKEVEN GRAPH

y
150 Total revenue

140 Total costs

130

120

110

100 Total variable costs

90
Rand values

80

70

60

50

40

30 Fixed costs

20

10

0
x
0 0,5 1 1,5 2 2,5 3
Activity

For purposes of this module, the contribution margin method will be applied for calculating the
breakeven point. You may be asked to calculate breakeven in either sales units or sales value.
Breakeven units
Assume the selling price per unit is R79, variable cost per unit is R39 and total fixed cost is R40 000.
We apply the following equation to calculate breakeven in units:
breakeven quantity = total fixed costs / contribution margin per unit
The contribution margin per unit is R79 – R39 = R40. Therefore, the breakeven quantity is
R40 000 / R40 = 1 000 units. The breakeven number of units to be manufactured and sold is 1 000
units. This information can be presented a marginal income statement format as follows:
Total for
1 000 units Per unit
R R
Sales 79 000 79
Less: Variable costs 39 000 39
Total contribution 40 000 40
Total fixed costs 40 000
Net profit/loss 0
This is the minimum number of units that must be sold to ensure that the fixed costs are covered and
that a loss is not suffered. It is also known as the breakeven quantity or breakeven volume. Where the
contribution margin exceeds fixed costs, a profit is made.
Breakeven value
The breakeven value is the sales value of the breakeven units, i.e., 1 000 × 79 = R79 000.
Breakeven value can also be calculated by dividing total fixed costs by the contribution margin ratio. If
the selling price is R79 and the variable cost is R39, then the contribution margin is R40 and the
contribution margin ratio is 40/79 = 0,506329. The breakeven value where total fixed cost = R40 000,
is: 40 000 / 0,506329 = R79 000.
breakeven (value) = total fixed costs ÷ contribution margin ratio

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How you determine the breakeven value in an examination will depend on the information that is
available.

Example 5.3
Consider the following Budgeted Contribution Income Statement for the production and sales of a
single product:
R
Total sales: 1 500 units 75 000
Variable costs 45 000
Contribution 30 000
Total fixed costs 20 000
Profit 10 000
The breakeven point in units is calculated as follows:
breakeven (units) = total fixed costs ÷ contribution per unit
Total contribution is R30 000 for 1 500 units, therefore contribution per unit is 30 000 / 1 500 = R20.
Breakeven units = R20 000 / R20 = 1 000 units.
The breakeven point in value is calculated as follows:
breakeven (value) = total fixed costs ÷ contribution ratio
The contribution ratio is contribution margin ÷ sales = 30 000 /75 000 = 0,4.
Breakeven value = R20 000 ÷ 0,4 = R50 000
Comparison of budgeted and breakeven contribution income statements
Actual Breakeven Excess Per unit Calculations
Units 1 500 1 000 500
R R R R
Total sales 75 000 50 000 25 000 50 75000/1500 = 50; 50 × 1000 = 50 000
Variable costs 45 000 30 000 15 000 30 45000/1500 = 30; 30 × 1000 = 30 000
Contribution 30 000 20 000 10 000 20
Total fixed costs 20 000 20 000 0
Profit 10 000 0 10 000

Note that the actual total profit of R10 000 from actual 1 500 units sold, is earned by the 500 units sold
in excess of the breakeven 1 000 units. Also note that total fixed costs were covered by sales of 1 000
units, therefore the excess sales of 500 do not have any fixed costs to cover and the contribution =
profit: 500 units × R20 = R10 000.

ACTIVITY 5.3

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 The volume of output which causes fixed costs to be equal in amount to total revenue is called
the breakeven point.
1.2 The breakeven point on a graph is indicated where the contribution margin line intersects with
the total costs line.
1.3 At the breakeven point, total fixed costs will always be equal to the total contribution margin.
1.4 Breakeven can be defined as the point where variable costs are equal to sales revenue.
1.5 If the contribution to sales ratio increases the breakeven point will increase.

QUESTION 2

For each of the following questions, read carefully through the information provided and select only the
most correct option as your answer.

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2.1 The breakeven point on the CVP graph occurs where …

(a) total profit is equal to total costs.
(b) total profit is equal to total fixed costs.
(c) total variable costs are equal to total contribution margin.
(d) total contribution margin is equal to total fixed costs.
2.2 Look at Figure 5.1. If the company decreases its total fixed costs while increasing the variable
cost per unit, the total costs line, relative to its previous position, will … on a CVP graph.
(a) shift upward and have a steeper slope
(b) shift upward and have a flatter slope
(c) shift downward and have a steeper slope
(d) shift downward and have a flatter slope
2.3 The … would not affect the breakeven point.
(a) number of units sold
(b) variable cost per unit
(c) total fixed costs
(d) selling price per unit
2.4 J Company Ltd has total fixed costs of R150 000, variable cost per unit of R500 and a breakeven
point of 1 000 units. The contribution per unit is …
(a) R650.
(b) R500.
(c) R150.
(d) R0.
2.5 SOSY Ltd manufactures and sells one product. The following is an extract from the budgeted
information for the financial year ending on 31 December
Number of units to be manufactured and sold 12 000 units
Selling price per unit R15,00
Variable selling cost per unit R0,75
Variable production cost per unit R4,20
Total fixed manufacturing cost R36 000
Total fixed selling cost R12 000
What is SOSY Ltd's breakeven point in units?
(a) 3 368,42 units
(b) 4 776,11 units
(c) 4 777 units
(d) 4 444 units

5.4 SENSITIVITY ANALYSIS FOR CHANGES IN VARIABLES

Planning for the future always occurs in conditions of uncertainty because we can only make
assumptions about what will happen in future; we cannot know for certain. The environment in which
an entity operates also changes, sometimes slowly and sometimes even unexpectedly. These changes
may occur within the company itself (e.g., union negotiations) or the industry within which it operates
(e.g., the bankruptcy of a major supplier) or the national economy (e.g., labour skills shortage,
economic growth) or even on the international stage (e.g., Covid-19). Any of the many potential
changes can affect costs and sales and, consequently, also the decisions of management. A sensitivity
analysis can show how changes in original estimates and assumptions will affect the original result.
With CVP analysis, different scenarios can be modelled to predict how identified potential changes
may impact on e.g., profit. All costs, i.e., production costs and administration expenses and marketing
and distribution expenses are separated into their fixed and variable components for purposes of the
analysis. Example 5.4 illustrates how a change in only one of the variables in the breakeven calculation
can affect decision-making. In this example we shall look at a change in selling price.

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Example 5.4
Lonely Planet is a small operation that prints T-shirts with slogans of sustainability. The owner, Dexter,
carefully tracks costs and uses CVP analysis on a spreadsheet to make sure that contribution margin
continues to cover fixed costs and returns a modest profit. Current data are as follows:

Selling price per T-shirt (R) 180

Variable cost per T-shirt (R) 155
Contribution margin per T-shirt (R) 25
Fixed costs (R) 30 000
Breakeven (number of T-shirts) 1 200 (R30 000 / R25)
Breakeven in rand (R) 216 000 (1 200 × R180)
After scanning the internet, Dexter comes to the conclusion that his selling price is at the lower end of
the market. Consequently, he wants to see how a modest increase in his selling price would affect his
profit. Dexter believes that if any increased price is still lower than his competitors’ prices, he will retain
his market share. He plots scenarios on his spreadsheet where the selling price per T-shirt is increased
by R15 and R20 respectively.

Current Add R15 Add R20

Selling price per T-shirt (R) 180 195 200
Variable cost per T-shirt (R) 155 155 155
Contribution margin per T-shirt (R)` 25 40 45
Fixed costs (R) 30 000 30 000 30 000
Break-even (number of T-shirts) 1 200 750 667
Break-even in rands (R) 216 000 146 250 133 333

Note that the above calculations were done on an Excel spreadsheet and that 667 units and R133 333 are rounded
figures; 30 000/45 = 666,66666 and 666,66666 × R200 = R133 333. Breakeven of 667 units at R200 each would
give a value of R133 400, but remember that these are planning figures only and will in all probability be prepared
on a spreadsheet like Excel.
Clearly, an increase in revenues result in an increase in contribution and a decrease in breakeven,
because the contribution to cover fixed costs is higher.
Above we looked at scenarios where the selling price per unit changes, but costs remain the same. We
shall now consider changes in the variable cost per unit, where the other variables remain the same.
The supplier of unprinted T-shirts informed Dexter of an imminent cost increase of R5 per T-shirt.
Dexter currently sells 1 500 T-shirts per month. He has calculated a new breakeven point and has
prepared a comparative contribution income statement to see what would happen to his profit at the
current sales level if he absorbs the cost increase at the current selling price of R180 per T-shirt.
Breakeven using contribution margin ratio:
New contribution: R25 – R5 cost increase = R20
Contribution ratio: R20/R180 = 0,111 (11,111%)
Breakeven in R (30 000 / 0,1111) = R270 000
Breakeven in units (R270 000 / R180) = 1 500
OR
Breakeven in units: R30 000 / R20 = 1 500

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Contribution margin income statement Current cost New cost

Expected unit sales 1 500 1 500
R R
Sales 270 000 270 000
Variable costs 232 500 240 000
Contribution margin 37 500 30 000
Fixed costs 30 000 30 000
Profit 7 500 0
Clearly, an increase in variable costs would result in a decrease in contribution and an increase in
breakeven, because the contribution to cover fixed costs is lower.
Dexter was shocked to find that this rather modest cost increase brought his business to breakeven
point. Any further cost increases would place Lonely Planet in a loss situation. Dexter now must either
find an alternative supplier, reduce other costs, or increase his selling price.

We shall now take a look at the effect of a change in the fixed cost, while the selling price and variable
costs remain the same.
Dexter is informed by his landlord that the lease of his business premises is up for renewal and that
rent will increase from R8 000 to R10 000 per month, i.e., an increase of R2 000. Dexter has prepared
a new breakeven analysis and contribution income statement that show the effect of the increase in
fixed costs.

Breakeven analysis Current cost New cost

Selling price per unit (R) 180 180
Variable cost per unit (R) 155 155
Contribution margin per unit (R) 25 25
Fixed costs (R) 30 000 32 000
Breakeven in units 1 200 1 280
Breakeven in rands (R) 216 000 230 400

Contribution margin income statement Current cost New cost

Expected unit sales 1 500 1 500
R R
Sales 270 000 270 000
Variable costs 232 500 232 000
Contribution margin 37 500 37 500
Fixed costs 30 000 32 000
Profit 7 500 5 500
An increase in fixed costs has no effect on the contribution margin; the contribution per unit remains
the same, but the breakeven point will be higher (i.e., more units) because a larger slice of the
contribution is now required to cover the additional R2 000 in fixed costs. If Dexter wishes to maintain
his profit level, he would have to look at ways to reduce fixed costs (e.g., find alternative premises) or
reduce variable costs, or increase his selling price.
________________________________________________________________________________

ACTIVITY 5.4

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).

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1.1 CVP analysis can assist management to understand the effect that changes in volume, selling
price, variable costs or fixed costs have on a product’s total costs, revenues and operating
income.
1.2 Within a given set of assumptions, sensitivity analyses determine how different values of an
independent variable affect the value of a particular dependent variable.

QUESTION 2

For each of the following questions, read carefully through the information provided and select only the
most correct option as your answer.
2.1 Cost-volume-profit analysis can be used as a sensitivity analysis technique to determine what
the effect of certain internal decisions of management or external changes will be on profits,
breakeven and margin of safety figures. If all other factors were kept constant, which one of the
following will lead to an increase in profit?
(a) Decrease in selling price per unit
(b) Decrease in sales volumes
(c) Increase in variable cost per unit
(d) Decrease in total fixed costs

5.5 MARGIN OF SAFETY

Whereas breakeven tells us how much sales we need before we start making a profit, the margin of
safety tells us by how much sales can drop (decrease) before we start making a loss, i.e., before we
reach breakeven. Margin of safety, therefore, is the revenue in excess of the breakeven revenue. The
margin of safety is useful in budgeting, especially where the entity is at risk of losing a significant portion
of its sales because of e.g., a major sales contract coming to an end.

A very large margin of safety protects the entity against fluctuation in sales levels, but a small margin of
safety may prompt management to reduce costs. The margin of safety is calculated by subtracting
breakeven sales from current sales, or, during budgeting, budgeted sales less budgeted breakeven sales.
For example, if budgeted sales revenue is R500 000 and breakeven sales revenue is R350 000, the
margin of safety is R150 000, or 30% (150 000 / 500 000). The margin of safety is usually expressed as
a percentage. As was the case with breakeven, the margin of safety can also be expressed in sales
volume (units of sales), although in multi-product companies R-values would work better.

In Figure 5.2 below, the margin of safety is indicated by the dotted area above the breakeven point,
where the revenue line lies above the total costs line. In the shaded area below the breakeven point,
where the total costs line lies above the revenue line, losses are incurred. The contribution margin is
indicated by the area between the revenue line and the total variable costs line.

Where revenue is strongly seasonal, e.g., back-to-school supplies and gardening tools,. some months
may show dire results and therefore a margin of safety analysis works best on annualised information.

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FIGURE 5.2: MARGIN OF SAFETY

Important formulae to understand are:

• Margin of safety (R) = budgeted sales – budgeted breakeven
• Margin of safety (units) = budgeted sales units – budgeted breakeven units
• Margin of safety ratio = margin of safety (R or units) / budgeted sales (R or units)

Example 5.5
Consider the information below:

Breakeven analysis:
Selling price per unit (R) 180
Variable cost per unit (R) 155
Contribution margin per unit (R) 25
Contribution margin ratio 13,9% (25/180 = 0,138889*)
Fixed costs (R) 30 000
Breakeven in units 1 200 (30 000 / 25 = 1 200)
Breakeven in rands (R) 216 000 (30 000 / 0,138889* = 216 000)
* We use unrounded numbers in calculations to reduce rounding errors.

Budgeted contribution margin income statement:

Expected unit sales 1 500
R
Sales 270 000 1 500 × R180
Variable costs 232 500 1 500 × R155
Contribution margin 37 500 1 500 × R25
Fixed costs 30 000
Profit 7 500

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The margin of safety in R-value, units and as a ratio is calculated as follows:

Margin of safety (R) = budgeted sales – budgeted breakeven
R270 000 – R216 000 = R54 000
Margin of safety (units) = budgeted sales units – budgeted breakeven units
1 500 – 1 200 = 300 units
Margin of safety ratio = margin of safety (R or units) / budgeted sales (R or units)
R54 000 / R270 000 = 0,2 or 20% OR 300 units / 1 500 units = 0,2 or 20%
________________________________________________________________________________

In the above example, if sales decline by more 20%, the entity will start incurring losses.

Example 5.6
The owner of Dorkas Dresses is thinking of buying an additional sewing machine and hiring an
additional seamstress to expand her business. The expansion will lead to an increase of 5% in sales
and current fixed operating costs of R900 000 will increase by R50 000. The current contribution ratio
is 48%. Current sales revenue is R2 000 000. Should Dorkas go ahead with the expansion?
Before expansion After expansion
Sales revenue (R) 2 000 000 2 100 000 
Contribution ratio 48% 48%
Contribution (R) 960 000  1 008 000 
Fixed product and period costs (R) 900 000 950 000 
Profit (R) 60 000 58 000
Breakeven (R) 1 875 000  1 980 000 
Margin of safety ratio 6,25% (0,0625)  5,71% (0,0571) 

 2 000 000 × 1,05 = 2 100 000

 48% × 960 000; 48% × 1 008 000
 900 000 + 50 000 = 950 000
 900000/0,48 = 1 875 000; 950 000 / 0,48 = 1 979 166,7 ≈ 1 980 000 rounded to nearest 10 000
 Margin of safety ratio = (sales – breakeven) / sales = (2000000 – 1875000) / 2000000 = 0,0625
(2 100 000 – 1 980 000) / 2 100 000 = 0,0571

Advice to Dorkas
The CVP analysis indicates that both the margin of safety and the profit will be adversely affected by
the expansion: the margin of safety is reduced from 6,25% to 5,71% and profit goes down from R60 000
to R58 000, while other variables (selling price and variable costs) remain the same. It is not advisable
that Dorkas proceed with the expansion. Dorkas could explore the feasibility of increasing selling prices
or decreasing costs.
________________________________________________________________________________

ACTIVITY 5.5

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 In a cost-volume-profit analysis, the R-amount by which actual sales exceed breakeven sales is
called the margin of safety.
1.2 The breakeven point on the CVP graph occurs where total profit equals total fixed expenses.
1.3 If total budgeted sales = R1 440 000; total budgeted fixed costs = R210 000; and the contribution
margin ratio = 20%, then the margin of safety will be R390 000.

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QUESTION 2

For each of the following questions, read carefully through the information provided and select only the
most correct option as your answer.
2.1 MSE Ltd has sales of 1 000 units. The selling price and variable cost per unit are R35 and R15
respectively. Fixed costs amount to R9 000. The margin of safety ratio is …
(a) 55%.
(b) 60%.
(c) 45%.
(d) 62%.
2.2 If the cost of direct materials increases, the breakeven point would … and the margin of safety
would …
(a) increase; increase.
(b) increase; decrease.
(c) decrease; decrease.
(d) decrease; increase.

QUESTION 3

Boka Ltd. produces and sells a single product. The following information is obtained from the budget
for the month ending 30 October:
R
Sales (20 000 units) 1 000 000
Direct materials 200 000
Direct labour 150 000
Manufacturing overhead costs:
Variable 70 000
Fixed 80 000
Selling and administrative costs:
Variable 100 000
Fixed 30 000
REQUIRED
Calculate the following (use three decimals in your calculations where appropriate):
3.1 The contribution per unit
3.2 The contribution ratio
3.3 The breakeven units and breakeven value
3.4 The margin of safety ratio (also interpret your answer)
3.5 The number of units that must be sold to earn a profit of R500 000
3.6 The breakeven units and breakeven value if the variable production costs per unit increase by
15% and the fixed selling and administrative costs increase by 10%
3.7 The change in net profit if the sales volume increases by 20% with no change in fixed costs

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QUESTION 4

Lebogang Ltd provides you with the following contribution income statement:
R R
Sales (75 000 units) 987 750
Less: Variable costs 600 000
Direct materials 225 000
Direct labour 150 000
Overheads 150 000
Selling costs 75 000
Contribution 387 750
Less: Fixed costs 305 000
Production overhead costs 110 000
Selling costs 45 000
Administrative costs 150 000
Net profit for the period 82 750
The upper boundary of Lebogang’s relevant range is a production capacity of 120 000 units per year.
REQUIRED
4.1 Calculate the margin of safety ratio, based on number of units.
4.2 The sales manager believes the company could increase sales by 15 000 units if advertising
expenditures are increased by R50 000. The supplier of the direct material will then allow a
quantity discount of 2,5% on all purchases. One additional supervisor will have to be appointed
to cope with the larger production volumes at a salary of R30 000 for the period. Prepare a
contribution income statement to show the effect of these proposed changes.
4.3 Calculate the breakeven point in units for the information in 4.2.
4.4 Refer to the information in 4.2. What is the maximum amount the company could spend on
advertising before it no longer benefits from the increased sales of 15 000 units?
4.5 Assume that the additional spending on advertising could lead to increased sales up to 120 000
units. Use the information in 4.2. above and calculate the number of units that must be sold in
order to generate a net profit of R225 000.
4.6 The general manager requests you to calculate the sales price and variable cost per unit if the
contribution ratio is 35% (which represents R4,75 per unit).

(Where appropriate, calculations rounded to three decimal places.)

QUESTION 5

Yambara Ltd manufactures and sells a skin-care product. The budget for the year, according to
which the company will work at 80% of its capacity (relevant range), is as follows:

R
Sales (10 000 units) 1 100 000
Variable costs (345 000)
Fixed costs (655 000)
Net profit 100 000

The company’s management are dissatisfied with the budgeted net profit and requests the sales
manager to increase turnover. The sales manager proposes the following independent alternatives:

 Decrease the selling price by 5% and increase the fixed costs by R30 000. This will result in a
10% increase in sales volume.
 Decrease the selling price by 10% and increase the fixed costs by R50 000. This will mean that
the company will operate at 100% capacity.
 Increase product quality and so increase the sales volume by 15%. The improvement in quality
will increase the variable cost per unit by 10% and the fixed costs by R40 000.
REQUIRED

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5.1 Without considering the sales manager’s proposed alternatives, calculate the following for the
budget as presented:
(i) The contribution ratio
(ii) The breakeven sales in value and in units
(iii) The margin of safety ratio
5.2 Calculate for each of the three alternatives:
(i) the net profit
(ii) the margin of safety ratio
5.3 Should management choose any of the sales manager’s proposals? Motivate your answer.

QUESTION 6

Ramalm (Pty) Ltd manufactures and sells a product called Secret Herb-and-Spice Blend (“SHSB”) in
large containers. The following information is available in terms of the 2020 and 2021 financial years:
Actual 2020 Budgeted 2021
R R
Direct materials costs 1 200 000 1 500 000
Variable manufacturing overheads 150 000 192 000
Other direct manufacturing costs (not included above) 225 000 288 000
Fixed manufacturing overheads 650 000 670 000
Selling and administration costs (semi-variable) 800 000 ?
Units Units
SHSB manufacturing and sales units for the year 50 000 60 000

Additional information

• The following actual quarterly information regarding the semi-variable selling and administration
costs is available for the 2020 financial year:
Quarter SHSB manufacturing Total selling and
and sales units administration costs
1 10 000 R182 500
2 13 000 R202 000
3 15 000 R217 500
4 12 000 R198 000
Total 50 000 R800 000
• Due to a change in commission structure, the budgeted variable selling and administration costs
per unit for the 2021 financial year is expected to be 30% higher than the actual variable selling
and administration costs per unit for the 2020 financial year.
• The budgeted fixed selling and administration costs for the 2021 financial year are expected to
remain at the same level as the 2020 financial year actual fixed selling and administration costs.
• The budgeted selling price per unit of SHSB is R70 for the 2021 financial year.
• No opening or closing inventory of any type is kept.
REQUIRED Marks
(a) Calculate the following actual figures for the 2020 financial year:
(i) Variable selling and administration costs per unit (3)
(ii) Fixed selling and administration costs per quarter (2)
(b) Prepare a memorandum to management in which you
(i) Calculate the budgeted breakeven point in units for the 2021 financial year. (4½)
(ii) Briefly explain the meaning of the budgeted breakeven point that you have calculated in (2)
(b)(i) for Ramalm (Pty) Ltd.
(iii) Compare the budgeted breakeven point calculated in (b)(i) with the budgeted SHSB sales (1½)
units and mention whether this will result in a margin of safety.
Memorandum format marks (2)
TOTAL 15
(Examination January/February 2021)

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5.6 TARGET PROFIT

Target profit (target income) is the profit that management wish to achieve in order to reach their
objectives of e.g., expanding operations or paying off existing debt. If breakeven is the level of sales
where the contribution margin is sufficient to only cover fixed costs without leaving a profit, then it
follows that if the target profit is added to the fixed costs before applying the breakeven formula, we
shall know what the sales must be to leave the target profit after fixed costs had been covered, i.e.,
target sales volume required = (total fixed costs + target profit) / contribution margin per unit.
Example 5.7
If the selling price per unit is R79, the variable cost per unit is R39 and fixed cost is R40 000, how many
units must be sold to achieve (i) breakeven and (ii) a target profit of R32 000?
Contribution per unit = R40 (70 – 39)
Fixed costs = R40 000
(i) Breakeven = 40 000 / 40 = 1 000 units
(ii) Target profit of R32 000 = (40 000 + 32 000) / 40 = 72 000 / 40 = 1 800 units
We can prove this answer:
1 800 units × R40 contribution per unit = R72 000
less: Fixed costs = R40 000
Target profit = R32 000
________________________________________________________________________________
Depending on the information available, any one of the formulae below may apply. You will either add
the target profit to fixed costs to determine the sales required to achieve the profit, or, when you are
provided with ratios only, you will subtract the target profit ratio from the contribution ratio so that profit
is covered before fixed costs.
The target profit is stated in R-value and you must calculate the volume of sales required to
achieve the target.
In this instance, you will add the target profit to the fixed costs and use the contribution margin to
determine the number of units to be sold:
target sales volume required = (total fixed costs + target profit) / contribution margin per unit
The target profit is stated in R-value and you must calculate the R-value of sales required to
achieve the target.
In this instance, you will add the target profit to the fixed costs and use the contribution margin ratio to
determine the R-value of sales required:
target sales value required = (fixed costs + target profit) / contribution ratio
or
target sales value required = target sales volume × selling price per unit
The target profit is stated as a ratio of sales and you must calculate the volume of sales required
to achieve a target.
In this instance, you will subtract the target profit per unit from the contribution margin per unit and use
the difference to determine the volume of sales required:
target sales volume = total fixed costs / contribution margin per unit – (x% × selling price per unit)
Example 5.8
The following information is available for the preparation of the budget of ABC Company:
Per Unit (R) Total (R)
Sales (5 000 units) 20 100 000
Less: Variable Costs (25% of sales) 5 25 000
Contribution Margin 15 75 000
Less: Fixed Costs 30 000
Profit 45 000

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Sales volume required to achieve a target profit of R80 000:

target sales volume required = (total fixed costs + target profit) / contribution margin per unit
= (30 000 + 80 000) / 15 = 7 333,33 i.e., 7 334 * units

Per Unit (R)Total (R)

Sales (7 334 units) 20 146 680
Less: Variable Costs 5 36 670
Contribution Margin 15 110 010
Less: Fixed Costs 30 000
Profit 80 010 (small difference due to rounding up)

* Remember: in calculating breakeven units we always round up and not down because 7 333
units will not take us to the required target profit: 7 333 × R15 = R109 995 – 30 000 = R79 995.

Sales value required to achieve a target profit of R80 000:

target sales value required = (fixed costs + target profit) / contribution ratio
contribution ratio = contribution margin / sales = 15/20 = 0,75 (75%)
= (30 000 + 80 000) / 0,75 = R146 700
OR
target sales value required = target sales volume × selling price per unit
= 7 334 × R20 = R146 680

Total (R) OR Total (R)

Sales 146 700 146 680
Less: Variable costs at 25% of sales 36 675 36 670
Contribution Margin 110 025 110 010
Less: Fixed Costs 30 000 30 000
Profit 80 025 80 010

Differences due to rounding

Sales volume required to achieve a target profit equal to 60% of sales:

target sales volume = total fixed costs / contribution margin per unit – (x% × selling price per unit)
= 30 000 / 15 – (0,6 × 20) = 30 000 / 15 – 12 = 30 000 / 3 = 10 000

Per Unit (R) Total (R)

Sales (10 000 units) 20 200 000
Less: Variable Costs 5 50 000
Contribution Margin 15 150 000
Less: Fixed Costs 30 000
Operating Income 120 000 (120 000 / 200 000 = 60%)

Note that in this instance we subtracted the required profit from the available contribution and then
made only the remainder of the contribution available for covering fixed costs.
________________________________________________________________________________

Remember that, in planning future volumes of production and sales, the target volume must always be
within the relevant range.

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ACTIVITY 5.6

QUESTION 1

Carefully consider the following statements and indicate whether they are TRUE (T) or FALSE (F).
1.1 Total sales units required to reach a target profit is determined by dividing the target profit by the
contribution margin per unit.
1.2 Breakeven analysis aims to determine the sales at which a company will break even or make a
target profit.

QUESTION 2

For each of the following questions, read carefully through the information provided and select only the
most correct option as your answer.
2.1 AC Limited manufactures a single product that has a selling price of R20,00 per unit. Fixed costs
are R45 000 per year and the company has a breakeven point of 5 000 units. The company has
a target profit of R13 500. Annual sales in units must be …
(a) 6 000.
(b) 5 750.
(c) 6 500.
(d) 7 925.
2.2 Sports Kits (Pty) Ltd plans to manufacture and sell 36 000 units of its product in the 2023 financial
year. Each unit has a total variable cost of R20 (R17 variable production costs per unit and R3
variable selling costs per unit). Fixed costs are R360 000 and the required profit is R180 000.
The required selling price per unit to achieve the target profit is …
(a) R10,00.
(b) R15.00.
(c) R20,00.
(d) R35,00.

QUESTION 3

Zimbani Ltd manufactures and sells a single product. The budgeted monthly information for the next
year is as follows:

Sales volume per month 70 000 units

Selling price per unit R5
Variable cost per unit R2
Fixed costs (annual cost / 12) R150 000
Initial investment R2 000 000

REQUIRED
3.1 Calculate the budgeted profit for the year by using cost-volume-profit principles. You do not need
to compile any income statement.
3.2 How many units must be sold per year if the company wishes to earn 10% net profit per year on
the initial investment?
3.3 What is the annual breakeven point in units and in value?
3.4 Using the annualised figures, assume there is an increase of 10% in fixed costs and an increase
to R2,50 per unit in variable costs. Calculate the following:
(i) The breakeven point in value and in units
(ii) The margin of safety value and the margin of safety ratio

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QUESTION 4
Lesenyeho Ltd manufactures and sells calculators. The company’s management accountant prepared
the following cost and revenue data for the forthcoming year:
Total (R) Per unit (R)
Sales 520 000 65
Variable costs ? ?
Fixed costs 109 200

Lesenyeho Ltd must sell 2 600 calculators in order to break even. It is expected that there will be no
closing inventory at the end of the year. There was no opening inventory.
REQUIRED
4.1 Calculate the following:
(i) The number of calculators produced and sold
(ii) The contribution per calculator
(iii) The variable cost per calculator
(iv) The breakeven value
(v) The number of calculators that must be sold to earn a profit of R75 600
4.2 Draw a breakeven graph that shows costs and sales from zero level of output up to budgeted
sales volume. Clearly indicate the breakeven point.
QUESTION 5
Ha-Ha Air SA Ltd (‘Ha-Ha SA’) is a company listed on the Johannesburg Stock Exchange. The
company operates an airline business and has a 31 March financial year-end.
Reporting to the Aviation Authority of Southern Africa (AASA)
AASA requires Ha-Ha SA to report on the operating expenses of the company on a monthly basis. The
Chief Financial Officer (CFO) has prepared the actual figures for the month ended 31 March 2020.
Description of costs Notes R
Flight operation costs 1 899 793
Depreciation and amortisation 958 013
Airport taxes and sundry levies 2 976 815
Passenger service costs 3 596 941
Administration and promotion costs 4 121 500
Notes
1. Flight operation costs comprise flight crew salaries, training and operating lease charges. Flight
operation costs are considered to be fixed in nature.
2. Airport taxes and sundry levies relate to taxes and levies that AASA charges Ha-Ha SA passengers
for passing through an airport and are considered to be variable in nature.
3. Passenger service costs are considered to be variable based on the number of passengers flown.
4. The 30% of the administration and promotion costs varies as per the number of passengers flown
and the other 70% is considered to be fixed by nature.
5. The prevailing market-related selling price (MRSP) of the ticketing and sales is R1 950 per ticket.
The ticket selling price of Ha-Ha SA is 70% of the MRSP per passenger. A total of 3 102
passengers were flown in the month ended 31 March 2020.
Key resolutions passed by Ha-Ha SA board
1. The Ha-Ha SA board decided not to involve the risk management division in their fuel hedging or
insurance decisions. Fuel remains Ha-Ha SA’s single biggest cost and will remain so for some time
to come. This has resulted into a financial loss to the company.
2. The board also took a resolution to procure goods and services from one service provider that is
connected to one of the directors of the company and the board is aware of the relationship. The
director in question did not declare the conflict of interest.
3. The board concluded unanimously to resist attempts to restructure the pilots’ unprecedented
evergreen service contracts that are a significant drain on the cash flow of Ha-Ha SA. These contracts
are costing Ha-Ha SA in excess of R600 million per year in excessive guaranteed benefits.

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REQUIRED Marks
(a) List and calculate the total actual fixed costs for the month of March 2020. (3)
(b) Calculate the point where the total contribution will be equal to total fixed costs (6)
(breakeven) for the month of March 2020.
Note: Round to two decimal places.
(c) Calculate the margin of safety percentage. (2)
Note: Round to two decimal places.
(d) Calculate Ha- Ha’s SA profit for the month of March 2020. Note: Round to the nearest (2)
decimal places.
(e) Calculate the sales amount if Ha-Ha SA were to increase its profit by 10% for the month (3)
of April 2020.
Note: Round to the nearest decimal places.
(f) Write a report stating your ethical concerns to the chairperson of AASA board about (7)
the Ha- Ha SA conduct. (Based on the Key resolutions passed by the board of Ha- Ha
SA.)
Note: Write your concerns in a report format.
TOTAL 23
(Examination May/June 2020)

5.7 SUMMARY

In this learning unit, you were introduced to cost-volume-profit (CVP) analysis (paragraph 5.2). CVP
analysis is a simple model, used within the relevant range, for predicting how profits respond to prices,
costs and volume. This model can be used to answer questions like what the company’s breakeven is in
volume and value, what its margin of safety is, and how they will be affected by changes prices, costs
and volume. Within the relevant range, it is assumed that cost and revenue functions are approximately
linear. We have identified and explained the assumptions underlying a CVP analysis, i.e., • total costs
and revenues are considered and all costs can be separated into either fixed costs or variable costs;
• total costs and revenues are linear functions of output; • all the units that are manufactured are sold;
• the analysis applies only to the relevant range; • the analysis applies to short-term planning only. We
also saw that the profits in a CVP analysis are calculated on a variable costing basis.
We explained the contribution margin and the contribution margin ratio (paragraph 5.2), showed how
they are calculated and demonstrated how they are used to determine breakeven and target profit. We
explained the margin of safety and margin of safety ratio and how they are calculated. You have learnt
that breakeven analysis is used to estimate the sales (volume and value) required to break even, i.e.,
to neither make a profit nor a loss. Breakeven was discussed in paragraph 5.3. The breakeven point
in volume of sales is determined by dividing total fixed costs by the contribution margin per unit. You
have also learnt that target profit analysis is used to estimate the sales (volume and value) required to
achieve a specified target profit. Target profit was discussed in paragraph 5.6. The volume of sales
required to achieve the target profit is determined by dividing the sum of the target profit and total fixed
costs by the contribution margin per unit. The margin of safety was discussed in paragraph 5.5. The
margin of safety is the amount by which sales (budgeted or actual) exceed breakeven sales. We also
looked at sensitivity analysis (paragraph 5.4) and how a change in a single variable can affect planning.
You also saw how the construction of breakeven and profit–volume graphs can assist managers to
obtain a clearer understanding of CVP behaviour. The breakeven graph (Figure 5.1) shows fixed costs
as a single horizontal line off the y-axis. Variable costs are depicted by a straight line, rising left to right
from the point where both x and y = 0. The total cost line is plotted parallel to the variable costs from
the base of the fixed costs, i.e., by adding variable costs to fixed costs. This is so because fixed costs
are assumed to be a constant within the relevant range. Total revenue is also shown as a straight line,
rising left to right from the point where both x and y = 0. Breakeven occurs where the total costs and
total revenue lines intersect.
Have you given any thought to ethics and to how you could integrate the knowledge from your other
modules in what you have learnt in this learning unit? Remember that CVP-analysis is used for
planning and decision-making and decisions have consequences. These calculations will be done by
the management accountant and presented to management. The management accountant must be
capable of preparing and interpreting the analyses before presenting them to management.

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