Cost-Volume-Profit Analysis

• Cost-Volume-Profit (CVP) analysis


  Examines the behaviour of total revenues, total costs and operating profit as changes occur in the output level, selling price, variable costs or fixed costs
• CVP analysis (special case)

  Assumes a single revenue driver and a single cost driver, which is units of output
• Changes in revenues and costs arise only because the output level changes in the CVP model
• Total costs


  Classified into two categories: variable costs (VC) and fixed costs (FC)
• Operating profit (OP)


  Total revenues - total cost
• Abbreviations used


  • USP = unit selling price
  • UVC = unit variable costs
  • UCM = unit contribution margin (USP-UVC)
  • FC = fixed costs
  • Q = quantity of output (units sold/manufactured)
  • OP = operating profit
  • TOP = target operating profit
• Assumptions of CVP analysis

  • Total costs can be divided into fixed and variable cost with respect to the output level
  • The behaviour of total cost and total revenues is linear (straight-line) in relation to output level
  • The unit selling price, unit variable cost and fixed costs are known and are constant
  • The analysis either covers a single product or assumes that the proportion when multiple products are sold will remain constant as the level of total units sold changes
  • All revenues and costs can be added and compared without taking into account the time value of money
  • Changes in the level of revenues and costs arise only because of changes in the number of products (or service) units produced and sold. The number of output units is the only revenue and cost driver
• Breakeven point


  The quantity of output where total revenues and total cost are equal, that is, where the operating profit is zero
• Calculating breakeven point


  1. Equation method: (USP x Q) - (UVC x Q) - FC = OP = 0

  2. Contribution margin method: (USP-UVC) x Q = FC + OP

  3. Graph method
• Calculating target operating profit


  REV-VC-FC = TOP
• Sensitivity analysis


  A what-if technique that examines how a result will change if the original predicted data are not achieved or if any underlying assumption changes
• Margin of safety


  The excess of budgeted revenues over the breakeven revenues
• Operating leverage


  The effect that fixed costs have on changes in operating profit as changes occur in units sold and hence in contribution margin
• Organisations with a high proportion of fixed costs have a high operating leverage, so a small change in sales lead to large changes in operating profit
• Rental alternatives for Mary's software sales


  • Option A: £2000 fixed fees
  • Option B: £1400 fixed fees plus 5% of revenues
  • Option C: 20% of revenues, no fixed fees
• Calculating contribution margin and breakeven point for each rental option

  1. Option A: UCM = £80, Breakeven = 25 units

  2. Option B: UCM = £70, Breakeven = 20 units

  3. Option C: UCM = £40, Breakeven = 50 units
• Option A has the highest operating leverage (26.67%) compared to Option B (20%) and Option C (10%)