COST VOLUME PROFIT ANALYSIS

Module 3 - syllabus

Cost-volume profit (CVP) Relationship: Profit planning- behavior of expenses in relation to volume- CVP model- sensitivity analysis of CVP Model for changes in underlying parameters- assumptions of the CVP Model- Utility of the Model in Management Decision Making.

Examines the behaviour of total revenues, total costs, and operating income as changes occur in the output level, selling price, variable costs or fixed costs

Assumptions of CVP Analysis 1. revenues change in relation to production and sales 2. costs can be divided in variable and fixed categories 3. revenues and costs behave in a linear fashion 4. costs and prices are known 5. if more than one product exists, the sales mix is constant 6. we can ignore the time value of money 7. Factor price, (e.g., material prices, wages rate) are constant at all sales volume. 8. The volume of production equals the volume of sales

Three ingredients of profit planning:

Cost of production. Selling prices &

Volume of units produced/sold.

These 3 factors are inter-dependent because cost

determines selling price to arrive at the desired level of

profit; the selling price affects the volume of sales, the volume of sales directly affects the volume of

production & volume of production in turn influences

cost. CVP is a tool to show the inter-relationship of these factors.

To determine the Break-even points in terms of units or sales value. To ascertain the margin of safety ratio. To estimate the profits or losses at various levels of output. To ascertain the likely effects of management decisions such as an increase or a reduction in selling price, etc., To determine the optimum selling price.

Break-even analysis (BEP)

The level of sales at which revenue equals expenses and net income is zero

It indicates at what level cost and revenue are

in equilibrium. It is a method of presenting to management the effect of changes in volume on profits. It reveals the effect of alternative decisions which

reduce or increase costs and which increase sales

volume & income.

Break-even point: It is defined as the point or sales level at which profit are zero and there is no loss. That is, BEP is that point at which total costs are equal to total sales revenue. At this point profit being zero, contribution (sales-v.c) is equal to the fixed cost.
Fixed Cost

BEP (in units) =

Contribution per unit F.C

BEP (in value)=

P/V (C/S) Ratio

Contribution It is the difference between the sales and the variable (marginal) cost of sales and it contributes towards fixed expenses and profit.

Contribution per unit = Selling Price Variable Cost Contribution = Fixed cost + Profit Revenue variable cost = Fixed cost + profit

It is the ratio which helps in studying the profitability of operations of a business and establishes the relationship between contribution and sales. Higher the ratio, more will be the profit and lower the ratio, lesser will be the profit. P/V Ratio is used in the following calculations: BEP. Profit at a given level of sales. The volume of sales required to earn a given profit. Profit when margin of safety is given. The volume of sales required to maintain the present level of profit, if selling price is reduced.

Formulae: P/V Ratio =

Contribution Sales

X 100

P/V Ratio = Change in Contribution

Change in Sales

X 100

P/V Ratio =

Change in profits
Change in Sales X 100

Calculation of Sales to earn desired Profit Sales to earn desired profit =

(in units) F.C + Desired profit

Contribution per unit

Sales to earn desired profit = F.C + D.P P/V Ratio (in value) Profit =
(Sales X P/V Ratio) Fixed Cost

It is the difference between the actual sales and

sales at BEP. MOS is that sales or output which

is above BEP. All F.C are recovered at BEP. If the MOS is large, it is an indicator of the strength of a business because with a substantial reduction in sales or prdn, profit shall be made. If the margin is small, a small reduction in sales or prdn will lead to a loss.

MOS = Actual Sales BE Sales MOS =

Profit P/V Ratio

OR

Angle of Incidence: This is the angle at which the sales line cuts the total cost line. It indicates the rate at which profits are being made. Large angle of incidence is an indication that profits are being made at a high rate. On the other hand, a small angle Indicates a low rate of profit and suggests that

V.C form the major part of cost of production. A

BEC is a graphical representation of marginal

costing. It is one of the most useful graphic

presentation of accounting data. This Chart shows the inter-relationship between cost, volume and profit. It shows the BEP and also indicates the estimated cost and estimated profit or loss at various volumes of activity.

Y Profit Area BEP Cost & revenue Loss Area AOI Sales Line TC line

V.C

F.C

BEP Sales

MOS Sales Output in units

Uses: 1. Helps to determine the BEP i.e. that level of sales where there zero profit & zero loss. 2. Helps to determine the sales volume to earn a desired profit or return on capital employed. 3. Helps to determine the selling price which will give the desired amount of profit. 4. Cost & sales at various levels of output may be determined. 5. Helps to determine the most profitable sales / product mix.

6. Comparative profitability of each product line or of different companies may be determined. 7. It studies the effect of change in selling price on profit. 8. Effect of increase or decrease in F.C & V.C on profit may be studies. 9. Effect on profit and BEP of high proportion of V.C with low F.C & vice versa may be determined. 10. Helps management in decision making such as make or buy decision, acceptance of a special job, discontinuance of a product line, etc.

1.The assumption that all costs can be clearly separated into fixed & variable components is not possible to achieve practically. 2. The assumption that V.C per unit remains constant and that it gives a straight line chart is not always true. 3. The assumption that F.C remains constant is also unrealistic. 4. The assumption regarding selling prices remaining unchanged as volume changes is also not true. 4. The assumption that only one product is being produced or that product mix will remain unchanged is also not found in practice.

6. It is assumed that the production & sales are synchronized which is need not be in practice. 7. It completely ignores the consideration of capital employed which may be an important factor in the study of profit analysis.

Pricing Decisions. Profit Planning & Desired Level of Profit. Make or Buy Decisions. Problem of Key or Limiting Factor.
Selection of a suitable or Profitable Sales Mix

Effect of changes in Sales Price. Alternative Methods of Production.

Determination of Optimum Level of Activity.

Evaluation of Performance.

Capital Investment Decisions.