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Chapter
3
Cost
Volume
Profit
Analysis
SYNOPSIS
Thischapterpresentsthecost-volume-profit(CVP)analysismodeland
illustrateshowmanagersusethatmodeltohelpanswerimportantwhat-if
businessquestions.
CVPanalysisalsohelpsmanagementaccountantsalertmanagerstothe
risksandrewardsofdecisionstheyareconsideringbyillustratinghowthe
bottom-lineisaffectedbychangesinactivitylevelsorkeypricingorcost
components.
CVPanalysisisbasedonseveralassumptions,oneofwhichisthatfixed
costscanbedistinguishedfromvariablecosts.
However,whetheracostisvariableorfixeddependsonthetimeperiodfor
thedecisionandalsotherangeofactivity(relevantrange)being
considered.
WealsolookatamethodforapplyingCVPanalysistocompanieswith
multipleproductsandtosituationswherethereismorethanonecostdriver.
TheapplicabilityofCVPtomanufacturers,serviceorganizations,and
nonprofitsisdiscussed.
Contributionmarginisalsodefinedanddistinguishedfromgrossmargin
Manageme
process of
nt
manageme
accounting
Strategy
nt involves
Planning
information Formulation
formulatin
helps
g strategy,
managers
planning,
perform
control,
each of
decision
Managers need cost information to
these
perform each of these functions. making
functions
and
more
directing
effectively.
operational
Directingactivities.
Control
Decision
Making
2-4
Basis of
classification :
(CAS 1)
i)
ii)
iii)
iv)
v)
vi)
vii)
Nature of
expenses
Relation to
object traceability
Functions/activ
ities
Behaviour
Management
decision
making
Production
process
Time period
Basis of
classification :
(CAS 1)
i)
ii)
iii)
iv)
v)
vi)
vii)
Nature of
expenses
Relation to
object traceability
Functions/activit
ies
Behaviour fixed, semivariable or
variable
Management
decision making
Production
process
Time period
Pay-Per-View
Movies
Total Pay-Per-View
Bill
Movies
Watche
2-8
Number of HBO
Movies Watched
Number of HBO
Movies Watched
2-9
Introduction
Till now we allocated all
manufacturing costs to products
regardless of whether they are fixed
or variable. This approach is known
as absorption costing/full costing
However, now, we will use only
variable costs which are relevant to
decision-making (why?). This is
known as marginal costing/variable
costing
10
BE Analysis
Or,
CVP analysis refers to the study of the effects on
future profits of changes in fixed cost, variable
cost, sales price, quantity and mix.
The analysis provides solutions to various
alternative business plans
Cost-volume profit analysis is also known as
Breakeven analysis and is used for decision making
Therefore, Breakeven analysis is the study of the
relationship between selling prices, sales volumes,
fixed costs, variable costs and profits at various
levels of activity
Continue.
Marginal cost:
It is the additional cost of producing an additional unit
of a product.
Defined as: the amount at any given volume of output
by which aggregate costs are changed if the volume of
output is increased or decreased by
one unit. Thus, it is
DL are included in
measured by the total variable cost
attributable
marginal
cost on to
theone
unit
assumption that they
are variable. If not,
they should be
excluded
It has to be
understood that all
variable costs are
generally direct costs
but all direct costs
need not be variable
In India Direct labour
cost are generally
treated as fixed, only
Absorption Costing
Cost
Manufacturing cost
Direct
Materials
Direct
Labour
Finished goods
Variable + Fixed
divided into sold &
unsold
Non-manufacturing
cost
Overheads
Period cost
Cost
Direct
Materials
Direct
Labour
Finished goods
Marginal Costing
Manufacturing cost
Unsold is
added to
stock
Non-manufacturing cost
Variable
Overheads
Fixed
overhead
Unsold
is
Period cost
added
to
stock
Profit and loss account
19
Features (contd):
2. Stock/Inventory Valuation : Under marginal costing,
inventory/stock for profit measurement is valued at marginal
cost. It is in sharp contrast to the total unit cost under
absorption costing method.
3. Marginal Contribution: Marginal costing technique makes use of
marginal contribution for marking various decisions. Marginal
contribution is the difference between sales and marginal cost.
It forms the basis for judging the profitability of different
products or departments.
4. Prices are determined on the basis of marginal cost
Advantages of marginal costing:
Simple, less confusing and less complicated
Stock valuation--Under this technique net profit is not effected
by the changes in production level or changes in stock volume;
in fact profit is directly related to sales.
Meaningful reporting--Reports based on this technique provide
information based on sales rather than production conveying
real estate of efficiency.
So
What is Marginal cost ?
The cost of producing one more unit
Or the cost which could be avoided by
not producing a unit
What is Marginal costing ?
An approach in which only variable costs
are included in cost of sales
fixed costs are treated as period costs
and are written off as incurred
Contribution Margin
Sales revenue
Variable costs
Contribution margin
Fixed costs
Profit
Contribution
Sales revenue
Less variable costs
Contribution margin
Less fixed costs
Profit
Total
Rs1,000,000
400,000
Rs 600,000
350,000
Rs 250,000
Per Unit
Rs2,000
800
Rs1,200
Ratio
100%
40%
60%
Therefore
C=S-V
=12,000-7000=5000
PROFIT P=C-F
?
=5,000-4000
=Rs 1,000
S=C+V
SALES? =5,000+7,000
=Rs 12,000
F COST? F=C-P
=5,000-1,000
=Rs 4,000
V=S-C
V Cost?
=12,000-5000
=Rs 7,000
Contribution marginisthedifferencebetweentotal
revenuesandtotalvariablecosts.Thisisanindication
ofwhyoperatingincomechangesasthenumberof
unitssoldchanges.
Contribution margin per unit isthedifferencebetween
sellingpriceandvariablecostperunit;i.e.,contribution
marginperunitisthechangeinoperatingincomefor
eachadditionalunitsold.
Contribution income statementisanincomestatement
thatgroupscostsintotheirvariableandfixed
components.Variablecostsaresubtractedfrom
revenuestohighlightcontributionmargin.Fixedcosts
aresubtractedfromcontributionmargintoarriveat
operatingincome.
Sales
$ 250,000
Less: variable expenses 150,000
Contribution margin
100,000
Less: fixed expenses
100,000
Net income
$
7-30
Profit way
What are BEP---assumptions
At the output level when total
All costs are fixed or
revenue equal to total cost.
variable
(Selling price X number of
VC remains Constant
units) (variable cost per unit
x number of units) fixed cost
Total FC remains
= operating profit
Constant
At Break even level operating
Selling Price dont
income is zero
change With Volume
Break even quantity = Fixed
Synchronization of Prod & cost / (selling price variable
cost)
Sales
No
Change in Contribution margin way
Methods
Productivity per workers
(Contribution margin x quantity)
Equation
fixed cost = operating income
Method
Break even quantity = Fixed cost /
contribution margin
Graphic
Method
Expressing CVP relationship
CVPrelationshipsandthecalculationofoperatingincomecan
beillustratedusingthreemethods:
Equation Method.Theequation methodisbasedonthe
followingformula:
(SellingpriceQuantityofunitssold)(Variablecostper
unitQuantityofunitssold)Fixedcosts=Operating
income
CP 1-2-3
Which of the following is not a factor in cost-volume-profit analysis?
a. Units sold
b. Selling price
c. Total variable costs
d. Fixed costs of a product
Equation Approach
Unit
Sales
Unit
Sales
sales volume variablevolume
price in units expense in units
(Rs200X)
Rs80,000 = Rs0
X = 400 units
Expenses can be separated in variable
and fixed expenses. At the breakeven point, income is Rs0.
7-34
Contribution-Margin Approach
Consider the following information developed by the
accountant at Curl, Inc.:
Total
$250,000
150,000
$100,000
80,000
$ 20,000
Per Unit
$
500
300
$
200
Percent
100%
60%
40%
7-35
Contribution-Margin Approach
Fixed expenses
=Break-even point
Unit contribution margin
(in units)
Therefore, the contribution margin
per unit is $200. When enough surf
boards are sold so that the total
contribution margin is $80,000, Curl
Inc. will break even for the period.
Total
$250,000
150,000
$100,000
80,000
$ 20,000
Per Unit
$
500
300
$
200
$80,000
= 400 surf boards
$200
Percent
100%
60%
40%
7-36
Contribution-Margin Approach
The break-even point of 400 units can be proven by first
calculating total sales: multiply $500 x 400 units for $200,000
in total sales. The variable expenses are $300 per unit x 400
units which is $120,000. Total sales less total variable
expenses is total contribution margin of $80,000. When fixed
expenses 0f $80,000 are deducted from the total contribution
margin, that leaves $0 in net income.
Total
$200,000
120,000
$ 80,000
80,000
$
-
Per Unit
$
500
300
$
200
Percent
100%
60%
40%
$80,000
40%
Total
$200,000
120,000
$ 80,000
80,000
$
-
Per Unit
$
500
300
$
200
Percent
100%
60%
40%
= $200,000 sales
7-38
AND
Contribution
= CM
margin
Ratio
Sales
Fixed expense Break-even point
=
CM Ratio
(in sales dollars)
7-39
Therefore
Cost- VolumeProfit
Fixed Cost
BEP (Units) = --------------=
Analysis
Contribution PU
Equation
METHOD
F
S-V
Fixed Cost
BEP (Rs ) = ----------------x Sales
Contribution
BEP (Rs)
Fixed Cost
Fixed Cost
= ------------------ = -----------------P/V Ratio
C/S
When P/V is calculated using unit contribution
and unit selling prices . We can write
Total fixed costs
BEP = ---------------------x Unit selling
prices
Unit contribution
And if P/V is calculated at given level of
activity
Total fixed costs
$80,000 + $100,000
= 900 surf boards
$200
7-42
Equation Approach
The equation approach also can be used to find the units of sales required
to earn a target net profit. Recall that in the profit equation, profit is equal
to revenues minus variable and fixed expenses. Recall that profit was set to
zero to determine the break-even point. When management has
determined a target net profit greater than zero, that number becomes
profit variable in the equation
$80,000 = $100,000
($500 X) ($300 X)$80,000
($200X)
= $180,000
X = 900 surf boards
7-43
Net incomeisoperatingincomeplusnonoperating
revenues(suchasinterestrevenues)minusnonoperating
expenses(suchasinterestexpense)minusincometaxes.
Tothispoint,wehaveignoredtheeffectofincometaxes
inourCVPanalysis.Tomakenetincomeevaluations,
however,wemuststateresultsintermsoftargetnet
incomeratherthantargetoperatingincome.
TheTOIcalculationcanbeeasilyadjustedto
accommodatethischange:
TargetNI=TOI(TOITaxrate)orstatedanother
way
TargetNI=TOI(1Taxrate)
Before-tax
=
net
7-45
5.How
c. 420,000
Costs/Revenu
e
Initiallyafirmwill
incurfixedcosts,
thesedonotdepend
onoutputorsales.
FC
Q1
Output/Sales
Totalrevenueisdeterminedbytheprice
chargedandthequantitysoldagainthis
willbedeterminedbyexpectedforecast
salesinitially.
Costs/Revenu
e
Break-Even Analysis
TR
TR
TC
Asoutputisgenerated,thefirmwill
incurvariablecoststhesevarydirectly
withtheamountproduced
VC
Initiallyafirmwillincur
fixedcosts,thesedonot
dependonoutputorsales.
Thetotalcoststherefore
(assumingaccurate
forecasts!)isthesumof
FC+VC
Thelowerthe
price,theless
steepthetotal
revenuecurve.
FC
Q1
Output/Sales
TheBreak-evenpointoccurswheretotalrevenueequalstotalcoststhefirm,inthisexamplewouldhaveto
sellQ1togeneratesufficientrevenuetocoveritscosts.
Break-Even Analysis
Costs/Revenue
TR
TR
TC
VC
Ifthefirmchosetoset
pricehigherthanRs2
(sayRs3)theTRcurve
wouldbesteeperthey
wouldnothavetosellas
manyunitstobreak
even
FC
Q2
Q1
Output/Sales
Break-Even Analysis
TR)
Costs/Revenue
TR
TC
VC
Ifthefirmchosetoset
pricesloweritwould
needtosellmoreunits
beforecoveringits
costs
FC
Q1
Q3
Output/Sales
Break-Even Analysis
TR
Costs/Revenue
TC
Profit
Loss
VC
FC
Q1
Output/Sales
Angle of
Incidence
Break-Even Analysis
Costs/Revenue
TR
Assume
current
salesatQ2
TC
TR
VC
Marginofsafetyshows
howfarsalescanfall
beforelossesmade.IfQ1
=1000andQ2=1800,
salescouldfallby800
unitsbeforealosswould
bemade
MarginofSafety
FC
Q3
Q1
Q2
Ahigherpricewouldlowerthebreakevenpointand
themarginofsafetywouldwiden
Output/Sales
Applying BE
Safety Margin
The
differenc
e
between
budgeted
sales
revenue
and
breakeven
sales
Sales
Less: variable expenses
Contribution margin
Less: fixed expenses
Net income
Break-even
sales
400 units
$ 200,000
120,000
80,000
80,000
$
-
Actual sales
500 units
$ 250,000
150,000
100,000
80,000
$
20,000
The
amou
nt by
which
sales
can
drop
before
losses
begin
to be
incurr
ed.
7-54
TR
TR
Angle of
Incidence
: The angle
between
sales and
total cost
line. This
angle is an
indicator of
Q1
Q3
Q2
Output/Sales
profit
earning
A large angle of incidence with high MS indicates monopoly
capacity
conditions
over the
BEP.