Cost-Volume-Profit Analysis Year 13 Accounting Cost-Volume-Profit Analysis

Cost-Volume-Profit It is a mathematical formula that shows the relationship between fixed cost, profit, selling price, variable cost and volume of output.

Purpose of Cost-Volume-Profit The purpose of CVP analysis is to help managers to calculate how many units are required to achieve breakeven or a desired profit level.

Formula for CVP Fixed Cost + Profit Units = Contribution Margin per Unit Contribution Margin/Unit = Selling Price – Variable Cost per Unit Breakeven means the business would make ZERO profit.

Contribution Margin The contribution margin is amount of sales available for covering fixed costs and profit after variable costs have been accounted for. This helps the business to determine how many units need to be produced in order to cover fixed costs (at least). The higher the contribution margin means more fixed costs (and profit) could be covered. The higher the contribution margin per unit means fewer units of output to breakeven.

Contribution Margin Formula Contribution Margin (per unit): Selling Price (per unit) – VC (per unit) Contribution Margin: Total Sales – Total Variable Cost Contribution Margin Percentage: Contribution Margin/Total Sales

Example Example 1

Margin of Safety This shows the number (or percentage) fall in sales volume (or number (or percentage) rise in sales volume) which will result in the firm being at breakeven. This helps the business assess how likely the business’s output to fall back to the breakeven level. Margin of Safety is the difference between expected (actual) sales unit and breakeven sales unit. The higher the Margin of Safety, less likely to have output dropped to breakeven point.

Margin of Safety Percentage Margin of Safety (in units) = Actual Units – Breakeven Units Margin of Safety (in dollar) = Actual Sales – Breakeven Sales

Margin of Safety (in diagram) Total Revenue BREAKEVEN Total Cost Margin of Safety Current Level of Output

Margin of Safety Percentage Margin of Safety (in Units or $) Actual Sales Volume (in Units or $) If the margin of safety percentage is 40%, this means the volume could fall by anything up to 40% before the business was at breakeven. If the margin of safety percentage is -20%, this means the volume would need to rise by 20% before the business was at breakeven.

Margin of Safety Percentage (40%) Total Revenue BREAKEVEN Total Cost 40% Margin of Safety Current Level of Output

Margin of Safety Percentage (-20%) Total Revenue BREAKEVEN Total Cost Margin of Safety 20% Current Level of Output

Example Let’s look at the example sheet together

Exercises Pages 5 – 6, Exercises 2, 4, 6, 8

Should I accept the order? A business should accept an order when: Financial Reason: If there is a positive contribution margin (this means all the variable costs could be covered and be able to cover some fixed costs) The units ordered is above the breakeven point. The units required is still below the relevant range – this means the business is able to produce the products using given resources. Positive Cash Flows (from Cash Budgets) Plus: Non Financial Reasons

No Right or Wrong Answer There is NO right or wrong answer in Management Decision. However, you need to JUSTIFY the reason why you make such a decision.