Cost-Volume-Profit (CVP) Analysis & Decision Making

CVP involves the determination of either of the variables (cost, profit or volume) given a relevant set of data. This
includes the price per unit, cost per unit, fixed cost, and/ or profit. In other words, CVP is a management
accounting tool that expresses relationship among sale volume, cost and profit.
Objectives of Cost-Volume-Profit Analysis
1. In order to forecast profits accurately, it is essential to ascertain the relationship between cost and profit on
one hand and volume on the other.
2. Cost-volume-profit analysis is helpful in setting up flexible budget which indicates cost at various levels
of activities.
3. Cost-volume-profit analysis assists in evaluating performance for the purpose of control thus enabling
management to take corrective actions where necessary and in good time.
4. Such analysis may assist management in formulating pricing policies by projecting the effect of different
price structures on cost and profit.
CVP is based on various assumptions as listed below:
1. Volume is the only factor affecting sales and expenses The changes in the level of various revenue and
costs arise only because of the changes in the volume of output produced and sold, e.g., bales of flour
produced by Unga Ltd. The number of output (units) to be sold is the only revenue and cost driver.
2. Total costs can be divided into fixed and variable components. Variable component will vary directly with
level of output. Direct materials, direct labour and direct chargeable expenses form the direct variable
costs while variable part of factory overheads, administration overheads and selling and distribution
overheads form the variable overheads.
3. There is linear relationship between revenue and cost.
4. The behavior of both sales revenue and expenses is linear throughout the entire relevant range of activity.
Graphically, it assumes a linear equation of the form Y= a + bx
5. The unit selling price, unit variable costs and fixed costs are constant.
6. The theory of CVP is based upon the production of a single product. However, of late, management
accountants are functioning to give a theoretical and a practical approach to multi-product CVP analysis.
7. There is only one product or service or a constant Sales Mix. The analysis either covers a single product or
assumes that the sales mix sold in case of multiple products will remain constant as the level of total units
sold changes.
8. All revenue and cost can be added and compared without taking into account the time value of money.
9. The theory of CVP is based on the technology that remains constant.
10. The theory of price elasticity is not taken into consideration.
11. Inventories do not change significantly from period to period:

Limitations of Cost-Volume Profit Analysis

The CVP analysis is generally made under certain limitations and with certain assumed conditions, some of which
may not occur in practice. Following are the main limitations and assumptions in the cost-volume-profit analysis:
1. It is assumed that the production facilities anticipated for the purpose of cost-volume profit analysis do not
undergo any change. Such analysis gives misleading results if expansion or reduction of capacity takes
place, which in most cases does.
2. In case a variety of products with varying margins of profit are manufactured, it is difficult to forecast
with reasonable accuracy the volume of sales mix which would optimize the
3. profit.
4. It assumes that input price and selling price remain fairly constant which in reality is not the case. Thus, if
cost or selling price changes, the relationship between cost and profit will not be accurately depicted.
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 5. It assumes that variable costs are perfectly and completely variable at all levels of activity and fixed cost
remain constant throughout the relevant range. However, this situation is not a practical one.
6. It is assumed that inventories do not change significantly from period to period. However, in reality,
opening inventory and closing inventory are never the same and in most cases they vary significantly.
7. Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore, closing stock
carried over to the next financial year does not contain any component of fixed cost. Inventory should be
valued at full cost in reality because such costs were incurred to bring the inventory into existence.

Cost Volume Profit (C.V.P) analysis by formula

C-V-P analysis can be undertaken by graphical means which are dealt with later in this chapter, or by simple
formulae which are listed below and illustrated by examples

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SPECIFIC NON-ROUTINE DECISION MAKING:
ACCEPT OR REJECT DECISIONS
Products are normally sold at cost plus profit and capacity may remain un-utilized due to demand constraints at
the current selling price. Companies may consider accepting offers at price below the current price so as to utilize
idle capacity If the revenue covers the relevant cost, the offer should be accepted.
Other factors to be considered for an accept or reject decision to be considered. They include; -
a. The firm’s policy regarding the selling price
b. Possibility of future demand of the company’s product
c. Whether the fixed cost will remain constant
d. Effect on other sales especially when the existing customers learn about the reduced selling price
e. Available idle capacity
ILLUSTRATION
TSLM Company Ltd. manufactures clothing and sells directly to clothing retailers. One of its departments
manufacture T-shirts. The department has a production capacity of 80,000 T-shirts per month. Currently, the
company has excess capacity which has resulted from liquidation of one of its major customers in the month of
April 2012. For the next quarter, monthly production and sales volume is expected to be 50,000 T-shirts. The
expected costs and revenues per T-shirt at this activity level are as follows:

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Additional information:
1. TSLM Company Ltd. is expecting an upsurge in demand and considers that the excess capacity is temporary.
2. ABC Ltd. has offered to buy for its employees 2,000 T-shirts each month for the next three months at a price of
Sh.95 per T-shirt.
3. ABC Ltd. would collect the T-shirts from TSLM Company Ltd. factory and thus no marketing and distribution costs
will be incurred.
4. ABC Ltd. would require its logo to be imprinted on the T-shirts. This would cost TSLM Company Ltd. an extra
Sh.5 per T-shirt.
5. TSLM Company Ltd. has an agreement with its employees that entitles the employees at least six months’ notice in
the event of any redundancies.
6. No subsequent sales to this customer are anticipated.
Required:
Advise TSLM Company Ltd. whether to accept or reject the offer from ABC Ltd

DROPPING A PRODUCT
From time-to-time management will be faced with the problem of deciding to abandon an unprofitable activity. This is
really a least-cost alternative decision and so made on the criterion of relative marginal costs.
It is sometimes suggested that, where a given product is apparently making a loss, manufacture and/or marketing of this
product should cease, to improve the company’s overall profit performance.

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MAKE OR BUY DECISIONS
This involves evaluating whether it will be advantageous to manufacture items or to purchase the items from outside
suppliers. Outsourcing is the process of obtaining goods or services from outside suppliers of providing the same services
within the organization.
In arriving on such a make or buy decision, the price asked by the outside supplier should be compared with the marginal
cost of producing the component parts. Other consideration affecting the decision is:
i. Continuity and control of supply e.g. can be the outsource company be relied upon to meet the
requirement in terms of quality, delivery dates and price stability.
ii. Alternatives use of resources. Can resource used make this article be transferred.
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LIMITING FACTORS DECISION MAKING
Limiting factor may be defined as ‘any factor, which has a limiting effect on the activities of an undertaking at a point in
time over a specific period’. The decision-making strategy, which management wish to pursue, may be constrained because
of shortage of manpower, machinery, material, money, markets or a combination of these. It may also be affected by the
availability of management expertise and methods improvement capability.
Where a single limiting factor exists, the decision-making sequence may be implemented as follows:

 Calculate the contribution per unit of limiting factor for each product.
 Rank the products in order of size and contribution per unit of limiting factor.
 Allow any minimum retention of less profitable products which is decided upon.
 Use up the total units of the limiting factor in order to fulfill the forecast quantities in order of product
ranking.

ILLUSTRATION
A company manufactures and sells three products A, B & c. The unit cost and revenue structure for each product and its
maximum forecast demand for the coming period are as follows:-

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The company has a maximum of 6000 machine hours available during the coming period. Annual fixed costs incurred
amount to Sh20,000.
Required
i. Calculate the number of units of each product A, B, and C, which should be produced and sold in order to maximize
profit
ii. Calculate the maximum profit earned from the decision strategy per (i) above.
iii. Suggest other factors which management may wish to consider which could result in a change in their decision.

*** the figure is the balance of machine hours remaining after allocating to other products in order of ranking.
iii. The profit maximizing mix may not be implemented where management wish to maintain a more balanced market mix
or where they wish to concentrate on a future market leader. In addition, they may wish to explore the possibility of sub-
contracting some production or of acquiring additional machinery either on hire or part of a long-term expansion of capacity

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