Cost behaviour and

cost-volume-profit
(CVP) analysis
 Learning Outcomes
• High-low method to separate fixed and
variable costs (Cost behaviour)
• CVP/Breakeven Analysis assumptions
• CVP/Breakeven Analysis formulas
• Breakeven Analysis and the public sector
• Breakeven Analysis and the private sector
• Limitations of CVP
• Efficient allocation of limiting factors
• Airline industry and Margin of Safety
 Major assumptions
1) Total costs are linear
2) Only one cost driver (e.g. labour hours, no of
units)
3) Costs are defined as variable or fixed with
respect to
a) a specific cost object (e.g. no. of units)
b) a defined time span
c) a particular ‘relevant range’ in the level of the cost
driver
See also: Bhimani et al., p. 38
 Analysing cost behaviour:
Variable and fixed costs

• Variable costs* • Fixed costs

– Costs that change in direct
proportion to changes in
activity (e.g. output
volume, time).
Costs
– Costs that remain
unchanged for a given time
period regardless of
changes in activity levels.
Costs

*Also called marginal costs

Activity level Activity level
 Semi Variable costs
A cost containing both fixed and variable
components and which is thus partly
affected by a change in the level of
activity.
Costs
Relevant
range

Activity level
 Stepped Fixed costs
If activity is expanded to the point where
further investment in fixed costs is needed,
e.g. a new factory premises is to be rented
then the rent cost will increase to a new,
higher level Relevant
Costs
range 3
Relevant
range 2
Relevant
range 1

Activity level
 High-low method
If scatter graph plot indicates a linear relation
between cost and activity, then we can estimate
the fixed and variable cost elements of a mixed
cost by using the high-low method .
The high-low method is based on the
rise-over-run formula for the slope of a straight
line.
Variable cost = Slope of the line = Rise/Run
=(Y2 – Y1)/(X2 – X1)
 High-low method (Steps)
1. Calculate increase in costs (Y axis) from
lowest to highest level
2. Calculate increase in output (X axis) from
lowest to highest level
3. Divide increase in costs (Y2 - Y ) by increase in
1

output (X2 - X ) to get variable cost per unit

1

4. Remains amount will be the fixed cost

element

Variable cost element must be linear and fixed

cost must be fixed/same within the relevant
range for this method to work
9
 Cost-Volume-Profit Analysis
Cost-Volume-Profit Analysis is a study of the
effects of changes in fixed cost, variable cost,
sales price/quantity mix on future profit.

More commonly used term is breakeven

analysis.
 Breakeven point
BE point (in units)
Fixed Costs
contribution / unit

Sales units required for desired (or target) profit

Fixed Costs + Desired Profit

contribution / unit

If any of the components is missing then it could be

calculated by inserting other numbers in the formula
 Sales in £ to achieve desired profit

Sales in £ = Fixed Costs+Desired Profit

C/S ratio
BE in £ = Fixed Costs
C/S ratio

Where
Contribution margin =C/S ratio = Contribution / unit
Selling price / unit
 Margin of safety
Margin of safety (units) =
budgeted sales units – breakeven sales units

Margin of safety (£):

MoS units x selling price = MoS in £s

OR

Budgeted sales £ – Breakeven sales £

Margin of safety % = (MoS units/Budgeted Sales units) x 100%

 Margin of Safety

Margin of Safety =
Budgeted Sales – Breakeven Sales
 Break-Even within the “relevant
range
In the graph on the
right has two Break- $’s TC
even points is on the
x-axis (Q) where TR
TR = TC (Q1 to Q2 on
graph)
So a relevant range cannot
have both points (Q1 and Q2 ) Profit
Q
Q represents quantity.
Q1 Q2
 Relevant range Assumptions
(Linear Break-Even Analysis)
• Over small enough range of output levels,
TR and TC may be linear, assuming
– Constant selling price/marginal revenue
(MR)
– Constant variable cost/marginal cost
(MC)
– Effectively means variable costs and
selling price per unit are fixed.
– Firm produces only one product
– No time lags between investment and
resulting revenue stream
 Graphic Solution Method

•Draw a line through TR

£
origin with a slope of P
TC
(product price) to
represent TR function MC
•Draw a line that 1 unit Q
intersects vertical axis at
level of fixed cost and has FC
a slope of MC P
1 unit Q Q
•Intersection of TC and TR
Break-even
is break-even point point
 Algebraic Solution
• Equate total revenue and total cost functions and solve for Q
TR = P x Q
TC = FC + (VC x Q)
TR = TC
P x Q = FC + VC x Q
(P x Q) – (VC x Q) = FC
Q (P – VC) = FC ; (Q (P – VC) would be total contribution)
Q = FC/(P – VC), or in terms of units of sales at BE point
Multiplying both sides with P of the equation to get the BE point in £.
PQ = (FxP)/(P-VC)
Dividing numerator and denominator with P to simplify the equation
further:
((FxP)/P)/((P-VC)/P) = F/((P/P) – (VC/P))
PQ = F/(1-VC/P) (1-VC/P is the same as the Contribution/Sales ratio.)
 Cost-volume-profit (CVP) analysis:
Analysing operating risk
Operating leverage Financial leverage

Used in CVP analysis Used in Fin. statement analysis

Relative mix of variable and
fixed costs
Sensitivity of operating
profit to changes in sales
Indicator of operating risk
Financial gearing/Debt-to-
equity ratio
Sensitivity of return to
shareholders to changes in
operating profit (due to high
interest in a highly geared
business)
Measure of financial risk
 Cost-volume-profit (CVP) analysis:
Analysing operating risk
• “Highly leveraged” operations
– High fixed cost compared to variable cost
(therefore denominator will become much
smaller to push the ratio up)
– Small changes in sales volume result in large
changes in operating income
More risky, because operating profit is highly
variable (Sales − variable cost)
Contribution margin
Opearting leverage =
Operating profit

(Sales − variable cost − fixed cost)

 Limitations of CVP Analysis
• Restrictive assumptions about cost behaviour:
– Linear cost behaviour
– Unchanged levels of operating efficiency (Relevant range) so not
applicable in case of the economies of scale; so relevant range is
crucial
– Possible to divide total costs accurately into fixed and variable
components
– Selling price may not be consistent for all customers in practice
• Time value of money is ignored; no inflation factors considered therefore
a short term decision tool.
• For more than one product in production it would be problematic to
apply CVP; e.g. how do we apportion fixed costs between different
products?
Cost-volume-profit (CVP) analysis: The
Profit-Volume Chart
£

Profit
164

0 Units of ice-
cream cones
BEV 910
-200