INDEX

INTRODUCTION
TARGET PROFIT
OBJECTIVE OF CVP ANALYSIS
BREAK EVEN POINT
MARGIN OF SAFETY
PROFIT VOLUME CHART
CVP IN MULTI PRODUCT SITUATION
ECONOMISTS VIEW OF CVP
CVP ANALYSIS AND UNCERTAINTY
THE PRINCIPLE OF MARGINAL COSTING
ADVANTAGES AND DISADVANTAGES
OF MARGINAL COST

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 INTRODUCTION

Cost-Volume-Profit (CVP) analysis is a vital tool used by businesses

to understand the relationship between costs, volume, and profit.
It assists in making various decisions such as pricing, production
planning, and setting sales targets. At the heart of CVP analysis
lies the concept of marginal cost, which plays a significant role in
determining the breakeven point and overall profitability.

Marginal cost refers to the additional cost incurred by producing

one more unit of a product or service. It includes only the variable
costs associated with production, such as raw materials, labor,
and direct overhead. Fixed costs, on the other hand, remain
constant regardless of the level of production in the short term,
such as rent and salaries. By focusing on marginal costs,
businesses can make informed decisions about production levels
and pricing strategies.

In CVP analysis, the breakeven point is where total revenue equals

total costs, resulting in zero profit. It can be calculated by dividing
fixed costs by the contribution margin per unit, where the
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contribution margin is the difference between the selling price per
unit and the variable cost per unit. Understanding the breakeven
point is crucial for businesses to determine the minimum level of
sales needed to cover costs and start generating profit.

Beyond the breakeven point, each additional unit sold contributes

to covering fixed costs and increasing profit. This is where
marginal cost becomes particularly relevant. As long as the selling
price per unit exceeds the marginal cost, selling additional units
will contribute positively to profit. However, if the selling price
falls below the marginal cost, the business will incur losses on
each additional unit sold.

CVP analysis also helps businesses assess the impact of changes in

sales volume, selling prices, and costs on profitability. By
conducting sensitivity analysis, businesses can identify the key
variables that have the most significant effect on their bottom line
and make informed decisions accordingly. For example, if a
business faces increased competition leading to a decrease in
selling prices, CVP analysis can help determine whether cost
reductions or increased sales volume are necessary to maintain
profitability.

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Furthermore, CVP analysis can aid in pricing decisions by
considering the relationship between costs, volume, and profit. By
understanding the cost structure and demand elasticity,
businesses can set optimal pricing strategies to maximize
profitability while remaining competitive in the market. For
example, businesses with high fixed costs and low variable costs
may benefit from lowering prices to stimulate demand and
increase sales volume.

In conclusion, Cost-Volume-Profit (CVP) analysis and marginal cost

play crucial roles in helping businesses understand the
relationship between costs, volume, and profit. By analyzing these
factors, businesses can make informed decisions about
production levels, pricing strategies, and overall profitability. CVP
analysis provides valuable insights that enable businesses to
navigate the complexities of the market and achieve their
financial goals.

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 TARGET PROFIT

In profit planning, management set profit targets and need

information such as the sales levels in units or revenue required
to achieve this target profit. The break-even formula can be
expanded to establish the volume required to achieve a desired
profit level

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 OBJECTIVE OF CVP ANALYSIS

The objective of CVP analysis is to establish what would happen

to profit if sales volume fluctuates in the short term.
The focus is on the volume of activity for a business, because
this is one of the most important variables affecting sales, costs
and profit.
The CVP model is based on the equation

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CVP FORMULA – MATHAMATICAL FORM

CVP & profit statement

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 BREAK EVEN POINT
The break-even point is the point at which neither a profit or a
loss is incurred. Break-even occurs where total contribution is
exactly equal to fixed cost and hence sales revenue is exactly
equal to variable cost plus fixed cost.

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EXAMPLE

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 BREAK EVEN CHART

Break-even charts give a graphical view of CVP analysis. The chart

is simple to understand and is particularly useful when
communicating to non-accountants. It gives a visual display of
how much output needs to be sold to make a profit and the
likelihood of making a loss, if actual sales fall short of targets.

Steps for break-even charts

Determine the parameters (maximum and minimum
activity/revenue) for the chart.
Draw an L-shaped chart with the X axis (horizontal line)
representing activity in units / covers / hours, and the Y axis
(vertical line) representing € sales / costs.
Map out the € sales on the Y axis and unit sales on the X axis,
starting with 0 (the point where the X and Y axis meet).
Draw the fixed cost line. The fixed cost line and should run
parallel to the X axis.
Draw the sales revenue line. The sales revenue line is a
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diagonal line from the origin to the maximum revenue point.
Draw the total cost line.
The break-even point is where the total cost line intersects the
revenue line.

SAMPLE OF BREAK EVEN CHART

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 MARGIN OF SAFETY
The margin of safety is the amount of sales the
business can afford to lose and still not make a
loss. It is the difference between the budgeted
sales volume (or revenue) and the budgeted
break-even volume (or revenue). It can be
expressed in units / products or € sales or as a
percentage.

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 PROFIT VOLUME CHART
The profit volume chart is very useful in showing the impact on
profit of different activity levels.

STEPS FOR PROFIT VOLUME CHARTS

The profit volume chart is very useful in showing the impact on

profit of different activity levels.
Draw the chart (like a T turned sideways to the left).
The vertical line represents profits and losses and the
horizontal line represents sales volume or € sales.
Only one line needs to be drawn, called the
contribution or profit line. The line joins the loss
incurred if activity level is zero to the maximum profit
point.

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SAMPLE OF PROFIT VOLUME CHART

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 CVP IN MULTI PRODUCT SITUATION

Many businesses in the hospitality, tourism and retail sectors sell

a variety of different products / services that generate different
contribution margins. In these multi-product firms, CVP analysis
can be used however it must be assumed that the proportion
each product represents of total sales (sales mix) remains
constant.
There are two ways of calculating the break-
even point and thus applying CVP analysis.
There are two ways of calculating the break-even point and thus
applying CVP analysis.
Calculate the break-even point for all products separately and
aggregate the answers to give an overall break-even point for the
business.
Calculate an average C/S ratio assuming that the
product sales mix remains constant.

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 ECONOMISTS VIEW OF CVP
Some of the above assumptions that underlie CVP analysis come
into conflict with economic theory, especially the assumption of
linearity and the constancy of selling price and variable cost per
unit.
Economists argue that lowering selling price acts as a catalyst to
increasing demand and thus as sales volumes increase, so will
variable costs. However, on account of economies of scale and
quantity discounts, the variable cost per unit should fall. This is
reflected in the total revenue and total cost curves that
economists use, rather than the straight lines simplifications in
the accountants CVP model.
The total revenue curve begins to slope upwards but less steeply,
as price reductions become necessary and then slopes downward
as the effect of price reductions outweigh the beneficial effect of
volume increases, as the business approaches capacity.
The total cost curve increases at a slower rate as the effects of
economies of scale and quantity discounts show up. However the
curve begins a steeper upward trend as the business rises towards

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full capacity, because the variable cost per unit will normally
increase as a result of diminishing returns.

ECONOMISTS VIEW OF CVP

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 CVP ANALYSIS AND UNCERTAINTY
The output and information provided by the CVP model is only as
good as its inputs. The model requires inputs such as likely sales
mix, selling price levels, total fixed costs and variable cost per unit.
These inputs are all estimated and thus will be subject to varying
degrees of uncertainty.

Risk can simply be defined as the likelihood that what is expected

to occur will not actually occur. Thus there is a strong possibility
that the financial estimates and inputs for the CVP model will not
turn out as expected. How do managers deal with this?

Sensitivity analysis
Use of probabilities
Simulations
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 THE PRINCIPLE OF MARGINAL COSTING

Since fixed costs are constant within the relevant range of volume
sales, it follows that by selling one extra unit or creating one extra
sale
Revenue will increase by the sales value of one item
Costs will only increase by the variable cost per unit
The increase in profit will equal sales value less variable costs, i.e.
the contribution
If the volume of sales falls by one unit, then profit will fall by the
contribution of that unit. If the volume of sales increases by one
unit, profit will increase by the contribution of that unit.

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 Fixed costs relate to time and do not change with
increases or decreases in sales volume. It voids the often arbitrary
apportionment of fixed cost and highlights contribution, which is
considered more appropriate for decision-making purposes.

MARGINAL V ABSORPTION COSTING

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 MARGINAL COSTING PROFIT STATEMENT

Contribution for each department is shown. Fixed cost is not

apportioned to the different areas or departments, therefore only
the total profit figure is shown.

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 ADVANTAGES OF MARGINAL COSTING
The marginal costing approach is preferable for decision-making,
as contribution is the most reliable criteria upon which to base a
decision.
It avoids arbitrary apportionment of fixed costs and the under- or
over-absorption of overheads.
Separating fixed and variable costs can help in short-term pricing
decisions. As fixed costs will remain unaffected by fluctuations in
activity within a relevant range, management can focus on
variable costs and contribution.
Fixed costs, by their nature, relate to periods of time rather than
volume of production and thus should be treated as such in the
preparation of profit statements.
It gives a more accurate picture of how an organisation’s cash
flows and profits are affected by sales and volume.
In manufacturing organisations, it avoids the manipulation of
profits through increased production volumes.

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 DISADVANTAGES OF MARGINAL COSTING
A marginal costing system identifies the contribution each item
earns. It does not establish the fixed cost per item, so there is a
danger that items will be sold on an ongoing basis at a price which
fails to cover fixed costs.
Marginal costing does not conform to the principles required by
the accounting standards for stock valuation, which requires that
stock is valued based on the total cost incurred in bringing the
product to its present condition and location. This is because no
element of fixed cost is included in the stock valuation provided
by marginal costing. Therefore, year-end adjustments are
necessary before the preparation of the financial statements
forreporting purposes.

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 BIBLIOGRAPHY
Here are some resources for Cost-Volume-Profit (CVP) analysis and
marginal cost:
1. "Cost Accounting: A Managerial Emphasis" by Charles T. Horngren,
Srikant M. Datar, and Madhav V. Rajan - This textbook provides
comprehensive coverage of CVP analysis and marginal costing.
2. "Managerial Accounting" by Ray H. Garrison, Eric W. Noreen, and Peter
C. Brewer - Another widely used textbook that covers CVP analysis and
marginal costing in detail.
3. "Management Accounting: Principles & Practice" by Leslie G.
Eldenburg, Susan K. Wolcott, and Philip E. Fess - This book offers practical
insights into CVP analysis and marginal costing.
4. "Introduction to Management Accounting" by Charles T. Horngren,
Gary L. Sundem, and Jeff Schatzberg - An introductory textbook that
covers the basics of CVP analysis and marginal costing.
5. "Cost-Volume-Profit Analysis: A Comprehensive Guide" by Steven M.
Bragg - A practical guidebook that delves into various aspects of CVP
analysis, including marginal costing.
These resources should provide you with a solid understanding of CVP
analysis and marginal cost concepts.

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