Session 2 Cost Volume Profit Analysis By the end of today’s session(s), you should be able to: • Compute breakeven activity and margin of safety (in monetary and unit terms) • Demonstrate an awareness of the assumptions and limitations of CVP analysis • Illustrate CVP analysis and breakeven analysis, using a graphical approach (to including multi-product analysis)
Competency Wheel Strategic Thinking & Problem Solving Communication Managing Self & Others:Leadership IT Awareness Project Management & Change Awareness Stakeholder Management Financial Reporting Management Accounting & Finance Audit & Assurance Tax & Law Strategy Ethics & Professionalism Objectivity Perceptiveness of own knowledge, values and limitations
Mapping • This lecture maps specifically to 5.1 on the Competency Statement
Cost Volume Profit Chapter Reference 9.2 (Pages 311 to 327)
Cost Volume Profit Analysis (CVP) CVP is a systematic method of examining the relationship between changes in activity (i.e. volume) and changes in total revenue, expenses and net profit. The model simplifies the real world and is subject to a number of assumptions and limitations. It is a good tool for decision making.
Assumptions / Limitations • Costs can be accurately divided into their fixed and variable elements • Fixed costs do not change • All other variables remain constant • Total costs and total revenue are linear functions of output • Profits are calculated on a variable costing (also known as marginal costing) basis • A single product or a constant sales mix. • The analysis applies to the relevant range only. • The analysis only applies to the short term.
Contribution vs Profit Contribution = Selling Price – Variable Costs Profit = Selling Price – (Variable Costs + Fixed Costs) Alternatively, Profit = Contribution – Fixed Costs Contribution represents an amount available to contribute towards fixed costs. It is normally expressed as a monetary amount.
Breakeven Point The point at which both fixed and variable costs are covered by revenue and no profit is made. It can be expressed in terms of either sales units or sales revenue.
Formulae Breakeven in Units Fixed Costs Contribution per Unit Breakeven in Sales revenue Fixed Costs Contribution to Sales Ratio OR Fixed Costs X Selling Price per Unit Contribution per Unit
Contribution to Sales Ratio Formula Contribution per unit or Total Contribution Selling Price per unit Total Sales Revenue This ratio measures how much contribution is earned from each €/£1 of sales. It is normally expressed a as %.
Margin of Safety This figures indicates the level by which sales could fall before a loss is made. It can be expressed in units, as a monetary amount or as a %.
Formulae Margin of Safety (in units) : Budgeted Sales units – Breakeven Sales units Margin of Safety (as a % of sales revenue) Budgeted Sales - Breakeven Sales X 100% Budgeted Sales
Target Profit Level of sales(units) required to generate the target profit Fixed Costs + Required Profit Contribution per Unit Or Target Contribution Contribution to Sales Ratio
Example 1 – Contribution to Sales Ratio The following information relates to Product J: Selling Price per unit 40.00 Variable Costs per unit 24.00 Fixed Costs 200,000 Requirement Calculate the contribution to sales ratio.
Solution 1 – Contribution to Sales Ratio Contribution to Sales ratio: Selling Price 40.00 Variable Costs (24.00) Contribution 16.00 C/S Ratio : 16.00 / 40.00 X 100 = 40%
Example 2 – Breakeven Point The following information relates to Product CT33. Selling Price per unit 30.00 Variable Costs per unit 19.50 Fixed Costs 280,000 Requirement Calculate the breakeven point in units and in terms of revenue.
Solution 2 – Breakeven Point Selling Price 30.00 Variable Costs (19.50) Contribution 10.50
Solution 2– Breakeven Point (continued) Breakeven Point (Units): Fixed Costs / Contribution per unit = 280,000 / 10.50 = 26,667 units Breakeven Point (Revenue): 26,667 units X €/£ 30 = €/£800,000
Alternative breakeven revenue formula Fixed Costs / Contribution to sales ratio, so we need to calculate the contribution to sales ratio first. The formula is : Contribution per unit / Selling price per unit 10.50 / 30.00 = 0.35 or 35% Using our alternative breakeven revenue formula: Fixed costs / Contribution to sales ratio €/£ 280,000 / 0.35 = €/£ 800,000
Example3 – Margin of Safety Star manufactures a product R2 to which the following relates: Selling Price per unit 35.00 Variable Costs per unit 21.00 Fixed Costs 175,000 Budgeted Sales Volume 16,500 Requirement Calculate the margin of safety in units and as a percentage of budgeted sales
Solution 3 – Margin of Safety To Calculate the Margin of Safety you will need to calculate the Breakeven point in units first. Selling Price 35.00 Variable Costs (21.00) Contribution 14.00
Solution 3 – Margin of Safety (continued) Breakeven Point : 175,000 / 14.00 = 12,500 units Margin of Safety (Units) Budgeted Units – Breakeven Units 16,500 – 12,500 = 4,000 units
Solution 3 – Margin of Safety (continued) Margin of Safety as % of Budgeted Sales Budgeted Sales – Breakeven Sales X 100 Budgeted Sales = 16,500 – 12,500 X 100 = 4,000 X 100 = 24.24% 16,500 16,500
Example 4 – Target Profit Star manufactures a product R2 to which the following relates: Selling Price per unit 38.00 Variable Costs per unit 24.00 Fixed Costs 210,000 Requirement Calculate the sales volume required to achieve a profit of €80,000.
Solution 4 – Target Profit Selling Price 38.00 Less Variable Costs (24.00) Contribution 14.00
Solution 4 – Target Profit (continued) Fixed Costs + Target Profit Contribution per unit 210,000 + 80,000 = 290,000 = 20,714 14.00 14.00
Example 5 – Comprehensive Examples Beta has the following information: Selling Price per unit 200.00 Variable Costs per unit 90.00 Fixed Costs 440,000 Budgeted Sales 6,500
Example 5 (Continued) Requirement • Calculate the c/s ratio • Calculate the breakeven point in terms of units sold • Calculate the breakeven point in terms of sales revenue • Calculate the units sales required to achieve a target profit of €520,000 • Calculate the margin of safety(expressed as a percentage of budgeted sales)
(a) Contribution / Sales Ratio Selling Price 200.00 Variable Costs ( 90.00) Contribution 110.00 C/S Ratio 110 / 200 X 100 = 55%
(b) Breakeven in Units Fixed Costs / Contribution per unit 440,000 / 110 = 4,000 Units
(c) Breakeven Revenue Breakeven revenue : Breakeven Units X Selling Price per unit 4,000 units X €/£200 = €/£ 800,000 Fixed Costs / Contribution to Sales Ratio 440,000 / 0.55 = 800,000
(d) Target Profit Fixed Costs + Target Profit = Contribution per unit 440,000 + 520,000 = 960,000 = 8,727 units 110 110
(e) Margin of Safety Budgeted Sales – Breakeven Sales Budgeted Sales = 6,500 – 4,000 X 100 = 2,500 X 100 = 38.46% 6,500 6,500
Constant Sales Mix Approach to Questions • Calculate the contribution per unit for each product. • Calculate the weighted contribution : Contribution per unit X % Total Sales Units • Calculate Breakeven Units : Fixed Costs / Weighted Contribution
Example 6 - Constant Sales Mix Acorn Ltd manufactures 2 products, AB12 and AB15. Sales of each product are made up as follows: AB12 60% AB15 40% Selling price and costs are as follows: Product AB12 AB15 Selling Price 20.00 22.00 Material per unit 8.00 9.00 Labour per unit 7.50 7.75 Fixed costs are estimated at €1,200,000 per annum. Requirement What are the breakeven units for each product?
Step 3 : Calculate Breakeven Point Breakeven Formula : Fixed Costs / Weighted Contribution per unit 1,200,000 / 4.80 = 250,000 units This breakeven figure represents the total sales of both products at which costs will be covered by sales revenue generated. Sales units of A : 250,000 X 60% = 150,000 units Sales Units of B : 250,000 X 40% = 100,000 units
Graphical Approach Need to be able to construct 3 Graphs: • Traditional Breakeven Graph • Contribution Breakeven Graph • Profit / Volume (P/V) Graph
Traditional Breakeven Graph Lines to be shown on the Graph: • Total Sales Revenue (TSR) • Total Costs (TC) • Fixed Costs Points to identify on Graph • Breakeven point where TSR intersects TC • Margin of Safety – Area between Budgeted Sales volume and Breakeven Sales Revenue
Breakeven Graph Total Sales Total Costs £’s Fixed Costs Units
Breakeven Graph Profit Area £’s Breakeven Point Loss Area Units
Breakeven Graph Profit £’s MOS Units
Breakeven Graph This graph depicts: • Approximate levels of profit/loss at different sales levels within a ‘relevant range’ • Breakeven point (total costs = total revenue) • Margin of safety (budgeted sales – breakeven sales)
Contribution Breakeven Graph Lines to be shown on the Graph: • Total Sales Revenue (TSR) • Total Costs (TC) • Variable Costs (VC) Points to identify on Graph • Breakeven point where TSR intersects TC
Contribution Breakeven Graph Total Sales Total Costs £’s Variable Costs Units
Contribution Breakeven Graph Contribution £’s Breakeven Point Units
Contribution Breakeven Graph • This graph includes a ‘variable costs’ line rather than a ‘fixed costs’ line The graph depicts: • Approximate levels of contribution at different sales levels within a ‘relevant range’ • Breakeven point (total costs = total revenue)
Profit / Volume Graph • X Axis – Sales in monetary Units • Y Axis – Profit & Loss Points to identify on the graph: • Breakeven Point – Point where the profit line intersects the Sales Axis
Profit Volume (P/V) Graph Total Profit £’s Breakeven Point Units