FIN 5107: FINANCE FOR
MANAGERS
TOPIC NO.6: CVP & BREAK EVEN ANALYSIS
Dr Muba Seif; PhD in Economics, University of HULL, UK.
Msc. BA (Finance, Banking and Insurance), VU University
Amsterdam, Holland.
CVP & Breakeven
Analysis
Is a systematic method of examining the
relationship between changes in activity (i.e.
output) and changes in total sales revenue,
expenses and net profit.
It helps managers to understand the relationships
between cost, volume and profit by focusing on
interactions between : Prices of products, level of
activity, per unit variable costs, total fixed costs
and mix of products sold.
Its main objective is to establish what will happen
to the financial results if a specified level of
activity or volume fluctuates.
Assumptions of
CVP Analysis
Constant sales mix or single product.
When pre determined sales mix is used, it can be
depicted in the CVP analysis by measuring sales
volume using standard batch sizes based on a planned
sales mix.
Volume is the only factor that will cause costs
and revenues to change.
All other variables (other than the particular one under
consideration) remain constant. However, changes in
other variables such as production efficiency, sales
mix, price levels and production methods can have
influence on revenue and costs.
Assumptions Cont…
Total revenue and total costs are linear
functions of output.
The analysis assumes that unit variable cost and selling
price are constant.
Analysis applies to relevant range and time
period only.
Relevant range is the range of activity within which the
assumptions about variable an fixed cost behavior are
valid.
Total Costs are linear and can be accurately
separated into their fixed and variable elements
Assumptions cont’…
All revenues and costs can be added,
subtracted and compared without taking into
account the time value for money.
In manufacturing companies, inventories do
not change. The number of units produced
equals the number of units sold
Selling price, variable costs per unit and total
fixed costs are known and constant.
Approaches to CVP
Analysis
A mathematical approach
The CVP relationship is expressed in a
simple profit planning equation.
Sales revenue=Variable costs+fixed costs+profit
Or S=VC+FC+NP
Approaches to CVP
Analysis
Contribution Margin Approach:
The expression p-vcu is called a unit contribution
margin.
Thus, contribution margin is the amount
remaining from sales revenue after variable
expenses have been deducted.
It is the amount available to cover fixed expenses
and then to provide profits for the period.
If it is not enough to cover fixed expenses, then
a loss occurs for the period.
Break even analysis
Breakeven point (BEP) is the quantity of
output sold at which the company’s
total sales revenue equal to its total
costs, hence, it neither makes profit nor
loss.
Units to be sold in order for the
company to break even is;
Contribution Margin Ratio (CM
Ratio)
It is also called profit-volume ratio, it is the
contribution margin divided by sales revenue.
CM Ratio= cmu/p
It represents the proportion of each shilling
sales revenue available to cover fixed costs
and to provide for profit.
It shows how the contribution margin will be
affected by a change in total sales.
Margin of Safety
The margin of safety indicates by how much
sales may decrease before a loss occurs.
In units, margin of safety is the sales quantity
minus breakeven quantity.
As a difference in revenues, margin of safety
can be expressed as
MOS = Expected Sales – Break-even
Sales
As a ratio (percentage) it can be expressed as;
exectedsales breakevensales
mos
exp ectedsales
Graphical Approach
In a CVP graph, unit volume is commonly represented
on the horizontal (x) axis and currency amounts on the
vertical (y) axis.
Draw line parallel to volume axis to represent fixed
cost.
Choose some volume of unit sales and plot the point
representing total cost at the activity you have
selected.
Choose some volume of unit sales and plot the point
representing total sales at the activity level you have
selected.
The point on the graph where total cost curve intercept
with the total revenue curve is the break even point.
Graphical Approach
Revenue
To
ta
lR
ev
en
ue
Tota
l Co
sts
X = Break-even point in units
Y = Break-even point in revenue
X
Unit sold
Illustration
ABC Company manufactures and sells a telephone
answering machine. The company’s contribution format
income statement for the most recent year is given below;
Total Per unit
Sales (20,000units) $1,200,000 $60
Less variable expenses 900,000 45
Contribution margin 300,000 15
Less fixed expense 240,000
Net income $ 60,000
Manager is anxious to improve the company’s profit
performance and has asked for several items of
information
Illustration
Required:
i. Compute the company’s CM Ratio
ii. Compute the company’s BEP in units and
dollars
iii. Refer to original data. Assume that next year
management wants the company to earn a
minimum profit of $90,000. how many units
will be sold to meet this target profit?
iv. Refer to original data. Compute the
company’s margin of safety.
