Management Accounting – Chapter 3 notes:
For example, it is not possible for a hospital to expand its facilities in the short run-in order to increase
the number of hospital beds. Similarly, a hotel cannot increase the number of rooms in the short run
to increase the number of guests. It is also important to remember that most of the costs and prices
of a firm’s products or services will already have been predetermined over a short-run period, and the
major area of uncertainty will be sales volume. Short-run profitability will therefore be most sensitive
to sales volume. CVP analysis thus highlights the effects of changes in sales volume on the level of
profits in the short run.
The term ‘volume’ is used within CVP analysis, but this has multiple meanings. Different measures
can be used to represent the term. For example, sales revenue is a generic term that can be used by
most organizations. However, units of output, or activity, tend to be the most widely used terms.
CVP analysis is dependent on the ability to estimate costs at different activity levels and to do this
requires that costs are analysed into their fixed and variable elements.
Total Revenue Function:
Linear CVP relationships assume that selling price is constant over the relevant range of output, and
therefore the total revenue line is a straight line. This is a realistic assumption in those firms that
operate in industries where selling prices tend to be fixed in the short term. Also, beyond the relevant
range, increases in output may only be possible by offering substantial reductions in price. As it is not
the intention of firms to operate outside the relevant range it is appropriate to assume constant selling
prices.
The profit-volume ratio (also known as the contribution margin ratio):
The contribution divided by sales. It represents the proportion of each £1 of sales available to cover
fixed costs and provide for profit.
Margin of Safety
This indicates by how much sales may decrease before a loss occurs. It is expressed as a percentage
form based on the following ratio:
Percentage margin of safety = expected sales – break even sales / expected sales
Higher margins of safety are associated with less risky activities.
Constructing the break-even chart:
Managers may obtain a clearer understanding of CVP behaviour if the information is presented in
graphical format. Activity/output is plotted on the horizontal axis and monetary amounts for total
costs, total revenues, and total profits (or loss) are recorded on the vertical axis.
, Break-even chart:
Contribution chart:
The advantage of this form of presentation is that it emphasizes the total contribution which is
represented by the difference between the total sales revenue line and the total variable cost line.
For example, it is not possible for a hospital to expand its facilities in the short run-in order to increase
the number of hospital beds. Similarly, a hotel cannot increase the number of rooms in the short run
to increase the number of guests. It is also important to remember that most of the costs and prices
of a firm’s products or services will already have been predetermined over a short-run period, and the
major area of uncertainty will be sales volume. Short-run profitability will therefore be most sensitive
to sales volume. CVP analysis thus highlights the effects of changes in sales volume on the level of
profits in the short run.
The term ‘volume’ is used within CVP analysis, but this has multiple meanings. Different measures
can be used to represent the term. For example, sales revenue is a generic term that can be used by
most organizations. However, units of output, or activity, tend to be the most widely used terms.
CVP analysis is dependent on the ability to estimate costs at different activity levels and to do this
requires that costs are analysed into their fixed and variable elements.
Total Revenue Function:
Linear CVP relationships assume that selling price is constant over the relevant range of output, and
therefore the total revenue line is a straight line. This is a realistic assumption in those firms that
operate in industries where selling prices tend to be fixed in the short term. Also, beyond the relevant
range, increases in output may only be possible by offering substantial reductions in price. As it is not
the intention of firms to operate outside the relevant range it is appropriate to assume constant selling
prices.
The profit-volume ratio (also known as the contribution margin ratio):
The contribution divided by sales. It represents the proportion of each £1 of sales available to cover
fixed costs and provide for profit.
Margin of Safety
This indicates by how much sales may decrease before a loss occurs. It is expressed as a percentage
form based on the following ratio:
Percentage margin of safety = expected sales – break even sales / expected sales
Higher margins of safety are associated with less risky activities.
Constructing the break-even chart:
Managers may obtain a clearer understanding of CVP behaviour if the information is presented in
graphical format. Activity/output is plotted on the horizontal axis and monetary amounts for total
costs, total revenues, and total profits (or loss) are recorded on the vertical axis.
, Break-even chart:
Contribution chart:
The advantage of this form of presentation is that it emphasizes the total contribution which is
represented by the difference between the total sales revenue line and the total variable cost line.
