COST – VOLUME – PROFIT ANALYSIS:Contribution Margin Approach & CVP Analysis

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Cost & Management Accounting (MGT-402)

LESSON# 29

COST VOLUME PROFIT ANALYSIS

(Contribution Margin Approach)

This topic is based on your knowledge of cost behavior and shows how this is applied in a

decision-making situation. Cost-volume-profit (CVP) analysis is a technique which uses cost

behavior theory to analyze the activity level as to the contribution margin and fixed cost

relationship and the level at which there is neither a profit nor a loss (the break-even activity level).

This is important management information because managers need to know the minimum activity

level that must be achieved in order that the business does not incur losses.

CVP analysis may also be used to predict profit levels at different volumes of activity based upon

the assumption that costs and revenues exhibit a linear relationship with the level of activity.

Cost-volume-profit analysis determines how costs and profit react to a change in the volume or

level of activity, so that management can decide the 'best' activity level.

Following are the assumptions which are used in CVP analysis.

1. Variable costs and selling price (and hence contribution) per unit are assumed to be unaffected

by a change in activity level.

2. Fixed costs, whilst not affected in total by a change in the activity level, will change per unit as

the activity level changes and there are more (or less) units over which to "share out" the fixed

costs If fixed costs per unit change with the activity level, then profit per unit must also

change.

Thus, cost-volume-profit analysis is always based on contribution per unit (assumed to be constant

unless a question clearly says otherwise) and never on profit per unit because profit per unit

changes every time a few more or less units are made.

CVP is a relationship of four variables

Sales

Volume

Variable cost

Cost

Fixed cost

Cost

Net income

Profit

This may be understood through the following equation

Volume @ sales price

Revenue

Cost matching with the sales

(Cost)

Result

Profit

CVP analysis is a tool for decision making. There are two approaches of CVP analysis:

1. Contribution margin approach

2. Break even analysis approach

Contribution Margin Approach & CVP Analysis

Contribution margin contributes to meet the fixed cost. Once the fixed cost has been met the

incremental contribution margin is the profit.

Income Statement as per the marginal costing system is used as a Standard format of Income

Statement to analyze the Cost-Volume-Profit relationship.

Rs.

181

Cost & Management Accounting (MGT-402)

Sales

xxx

Variable Cost

xxx

Contribution Margin

xxx

Fixed Cost

xxx

Profit

xxx

PRACTICE QUESTION

Basic question

90 units of product "PR" is sold for Rs. 100 per unit. Variable cost relating to production and

selling is Rs. 75 per unit and fixed cost is Rs. 2,250.

Q. 1. Management decides to increase its sales by 10 units.

Required:

Prepare income statement and analyze.

Solution

Rs.

Sales (90 x 100)

9,000 (10 x 100)

1,000

10,000

Variable cost (90 x 75)

(6,750) (10 x 75)

(750)

(7,500)

Contribution margin

2,250

250

2,500

Fixed cost

(2,250)

2,250

Profit / Loss

250

Analysis

This shows physical increase in volume causes an increase in contribution margin and if there is

not increase in the fixed cost because of such change, the incremental contribution margin is added

in the final profits.

Q. 2. Management decides to increase its sales price by 10%. Continue with the Q. 1.

Required:

Prepare income statement and analyze.

Solution

Sales

100 x Rs 110

11,000

Variable cost 100 x Rs. 75

(7,500)

Contribution margin

3,500

Fixed cost

(2,250)

Profit

1,250

Analysis

This shows increase in sales price per unit causes an increase in the contribution margin, as there is

not change in the volume the fixed will remain unchanged. So the incremental change is

contribution margin is included into the profit.

Q. 3. Management decides to decrease its sales price by 10%. Continue with the Q. 1.

Required:

Prepare income statement and analyze.

Sales

100 x Rs 90

9,000

Variable cost 100 x Rs 75

(7,500)

Contribution margin

1,500

182

Cost & Management Accounting (MGT-402)

Fixed cost

(2,250)

Loss

(750)

Analysis

This shows decrease in sales price per unit causes a decrease in the contribution margin, as there is

not change in the volume the fixed will remain unchanged. So the change in contribution margin is

subtracted from the profits, which result into a loss of Rs. 750 in this case.

Normally a decrease in sales price should case an increase in the sales volume.

Q.4. Management decides to decrease its sales price by 10% and expects an increase in sales

volume by 50%. Continue with the Q. 1.

Required:

Prepare income statement and analyse.

Solution

Sales

150 x Rs 90

13,500

Variable cost 150 x Rs 75

(11,250)

Contribution margin

2,250

Fixed cost

(2,250)

Loss

Analysis

This shows decrease in sales price per unit causes a decrease of Rs. 1,000 in the contribution

margin, as well as an increase in volume is causing an increase in the profit, this results in an

increase in profit.

Here in this scenario the increase in the volume must be more than 50% to earn profits.

Q.5. Management decides to decrease its sales price by 10% and expects an increase in sales

volume by 200%. Continue with the Q. 1.

Required:

Prepare income statement and analyse.

Solution

Sales

200 x Rs 90

18,000

Variable cost 200 x Rs 75

(15,000)

Contribution margin

3,000

Fixed cost

(2,250)

Profit

750

Analysis

This shows decrease in sales price per unit causes a decrease of Rs. 1,000 in the contribution

margin, as well as an increase in volume is causing an increase in the profit, this results in an

increase in profit.

Here in this scenario the increase in the volume must be more than 50% to earn profits.

Q.6. Management decides to increase its sales volume by 100% and it is also assumed that the

fixed cost also increase upto Rs. 2,500. Continue with the Q. 5.

Required:

Prepare income statement and analyse.

Solution

Sales

200 x Rs 90

18,000

Variable cost 200 x Rs 75

(15,000)

Contribution margin

3,000

Fixed cost

(2,500)

Profit

500

Analysis

183

Cost & Management Accounting (MGT-402)

This shows a decrease in fixed cost causes a decrease in the profits.

Q.7. Management decides to increase its sales volume by 100% and it is also assumed that the

fixed cost also increase upto Rs. 2,500, and also there is an increase of 20% in the variable cost.

Continue with the Q. 6.

Required:

Prepare income statement and analyse.

Solution

Sales

200 x Rs 90

18,000

Variable cost 200 x Rs 90

(18,000)

Contribution margin

Fixed cost

(2,500)

Loss

(2,500)

Sales

***

Variable cost

(***)

Contribution margin

***

Fixed cost

(***)

Profit / Loss

***

This lesson ends up at following lessons:

1. At zero contribution margin the loss will be equal to the fixed cost

2. Increase in variable cost reduces the contribution margin

3. Sales Variable cost = Contribution margin

4. Contribution margin + Variable cost = Sales

5. Contribution margin Fixed cost = Profit

6. Profit + Fixed cost = Contribution margin

7. Sales - Variable cost = Fixed cost + Profit

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