NOTE: This is a work in progress.

All topics in the syllabus are covered but editing for

necessary corrections is in progress.
Thanks.

CHAPTER NINE

COST-VOLUME-PROFIT ANALYSIS

Learning Objectives:
After studying this chapter, you should be able to:
 explain the concept of break even analysis.
 state the assumptions behind break even analysis.
 explain the meaning and importance of C-V-P analysis.
 use C-V-P analysis for short run planning and decision-making.
 compute break-even point by graphical and mathematical approaches.

9.1 Break-Even Analysis

9.1.1 The Concept of Break-Even Analysis

Break even is a situation of neither profit nor loss; it is about a win-win or loss- loss
position as two competing things or persons are put together to realize a result. In
Accounting, especially Management Accounting, break even is normally studied taken
the point of intersection between cost and revenue into consideration. That point of
intersection is called breakeven point and it shows a situation of neither profit nor loss.

The study of Cost-Volume-Profit relationship is frequently referred to as 'break-even

analysis', but break even analysis is only incidental to the study of the relationship
between cost, sales, profit/loss and sound management. Up to the point of activity
where total revenues equal total expenses, the study can be termed as 'break-even
analysis', while, beyond this point, it is the application of Cost-Volume-Profit
relationship.

Thus, the term 'break-even analysis' may be interpreted in two senses - narrow sense and
broad sense. In its narrow sense, it refers to a system of determining that level of
operations where total revenues equal total expenses, i.e. the point of zero profit. Taken
in its broad sense, it denotes a system of analysis that can be used to determine the
probable profit at any level of operations.

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necessary corrections is in progress.
Thanks.

9.1.2 Assumptions of Break-even Analysis

Break even analysis and Cost-Volume-Profit analysis are based upon certain assumed
conditions which are to be rarely found in practice. Some of these basic assumptions
are as follows:
i. The principle of cost variability is valid.
ii. Costs can be resolved into their fixed and variable components.
iii. Fixed costs remain constant.
iv. Variable costs vary proportionally with volume.
v. Selling price does not change as volume changes.
vi. There is only one product or, in the case of multiple products, sale mix remains
constant.
vii. There will be no change in general price level.
viii. Productivity per worker remains mostly unchanged.
ix. There is synchronization between production and sales.
x. Revenue and costs are being compared with a common activity base, e.g. sales
value of production or units produced.
xi. The efficiency of plant can be predicted.
A change in any one of the above factors will alter the break-even point so that profits
are affected by changes in factors other than volume. Thus, the break-even chart must
be interpreted in the light of the limitations of underlying assumptions, especially with
respect to price and sale mix factors.

9.1.3 Presentation of Break-even Analysis

Usually, 'break-even analysis' is presented graphically as this method of visual
presentation is particularly well-suited to the needs of business owing to the manager
being able to appraise the situation at a glance. Thus, it removes the danger
accompanying many accounting reports, a danger that the reader would get bogged
down with unnecessary details in such a way that he may never come to grips with the
heart of the matter. The graphical break-even analysis eliminates the details and presents
the information in a simplified way. To that extent, it is especially attractive for a person
of non-accounting background. When presented graphically the break-even analysis
takes the shape of 'break-even‟ chart or charts.

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Thanks.

A break-even chart shows the profitability, or otherwise, of an undertaking at various

levels of activity and, as a result, indicates the point at which neither profit is made
nor loss is incurred.

Break-even charts are frequently used and needed where a business is new or where it is
experiencing trade difficulties. In these cases, the chart assists management in
considering the advantages and disadvantages of marginal sales. However, in a highly
profitable enterprise, there is little need of break-even charts except when studying the
implications of a major expansion scheme involving a heavy increase in fixed charges.

Illustration 9.1: Graphical demonstration

A company makes and sells a single product. The variable cost of production is N3 per unit, and
the variable cost of selling is N1 per unit. Fixed costs total N6,000 and the unit selling price is
N6. The company budgets to make and sell 3,600 units in the next years.

Required: A break-even chart and a Profit-Volume graph, each showing the expected amount
of output and sales required to break even, and the safety margin in the budget.

Solution
A break-even chart records the amount of fixed costs, variable costs, total costs and total
revenue at all volumes of sales and at a given sales price as follows:

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Figure 1: Break Even Chart

N
Cost

TR TC
21,600 profit
Break-even point (BEP)
18,000 margin of
Total cost safety
Revenue
loss
6,000 Fixed costs

0 1000 2,000 3,000 3,600 4,000 output/sales

(units)
The break-even point is where revenues and total costs are exactly the same, so that there is
neither profit nor loss. It may be expressed either in term of units of sale or in terms of sales
revenue. Reading from the graph (above), the break-even point would be determined as
3,000 units of sale and N
= 18,000 in sales revenue.

The margin of safety is the amount by which actual output/sales may fall short of the budget
without incurring a loss, usually expressed as a percentage of the budgeted sales volume. It is
therefore a crude measure of the risk that the company might make a loss if it fails to achieve
budget. In this example, the margin of safety is:
Units
Budgeted sales 3,600
Break-even point 3,000

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Margin of safety (MOS) 600

As a percentage of budgeted sales:

the MOS = 600/3,600 x 100% = 16.67%

A high margin of safety indicates a good expectation of profit, even if budget is not achieved. In
our example, it would not be clear without further investigation whether the safety margin in the
budget is sufficient to indicate a good prospect of making profits. (In other words, it would not
be clear whether the forecast of 3,600 units of sale might be over optimistic by more than
16.67%).

9.2 Cost- Volume- Profit Analysis

9.2.1 The Concept of Cost- Volume- Profit

Cost-Volume-Profit (CVP) analysis involves the analysis of how total costs, total revenues and
total profits are related to sales volume, and is, therefore, concerned with predicting the effects
of changes in costs and sales volume on profit. It is an analysis that guides decision making in
respect of going into a production process, expanding an existing production level or
diversifying into unusual areas of operations. The analysis could be done graphically or
mathematically.
CVP analysis seeks to find out answers to the following questions:
 What would be the cost of production under different circumstances?
 What has to be the volume of production?
 What profit can be earned?
 What is the difference between the selling price and cost of
production?
If carefully used, the technique might be helpful in:
i. budgeting process. The volume of sales required to make a profit and the "safety
margin" for profits in the budget can be measured;
ii. pricing decision and sales volume decisions;
iii. sales mix decision, i.e. in deciding what proportions of each product should be sold?
iv. decisions affecting the cost structure and production capacity of the company.

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