Cost Volume Profit Analysis

A tool for decision making

Source- Cost Accounting – A
managerial emphasis by Horngreen,
Datar & Foster [ Chapter-3]
 Learning objectives
Understanding
• CVP analysis and its strategic role
• CVP analysis for BEP planning
• CVP analysis for revenue & cost planning
• Sensitivity analysis when sales are uncertain
• Multi-product situation & CVP analysis
• Multiple cost driver situation
• Use in decision making
• Limitations and effect on interpretation of results
 Marginal costing
A TECHNIQUE USED IN DECISION MAKING
- If the volume of output increases, the
average cost per unit will decrease.
Conversely, if the output is reduced, the
average cost per unit will go up
 CVP Analysis
a method for analysing how operating and
marketing decisions affect net income

CVP model:
Profit = Revenue – Total cost
= Q x SPU – Q x VCU - FC
 CVP analysis
WHAT IF?
Change in:
Behaviour of:
Output level
Total revenue
Selling price
Total cost
VC per unit
Operating income
And/or fixed cost of a
product
 Applications of CVP Analysis
Setting prices for products and services
New product/service introduction
Replacing a machine
Make or buy
What if analysis
 Strategic role of CVP analysis
• Cost leadership firms compete by increasing volume to
achieve low per unit operating cost- predict effect of
volume on profit and risk of increasing FC
• Early stage of cost life cycle- predict the profitability of
the product
• Use in target costing – profitability of alternative designs
• Later phases of life cycle- mfg. stage- evaluate most
profitable mfg. process
• Helps in strategic positioning-
- differentiation- assessing desirability of new features
- cost leadership- low cost operating means
 Some terms
• Operating income = Gross operating
revenue – COGS and operating costs
• Net income = operating income + net non-
operating revenues – income tax
• Contribution margin = contribution margin
per unit X No. of units sold
 BEP
Equation method:
Revenue-variable cost – fixed cost = operating income

[SP X Q] – [VCU X Q]- FC = Operating income

At BEP, operating income = “Zero”

 BEP
Contribution margin method: rearranging the
equation
[SP X Q]- [VCU X Q] –FC = OI

Or, [SP-VCU] X Q = FC + OI
At BEP, [SP-VCU] X Q = FC
i.e., CMU X Q = FC
Hence, Q = FC / CMU (in terms of number)
Q = FC / PV ratio (in terms of revenue)
 PV ratio
PV ratio = CMU/SP
- a % figure
- a rate of profitability
Uses of PV ratio:
– 1- P/V ratio = Variable cost ratio
– Sales X P/V ratio = Gross contribution
– Determining the sales mix
– BEP = FC / PV Ratio
– [FC+ Target Profit ] / PV ratio gives the volume of
output to be sold to earn a desired level of output
 Improving PV ratio
improvement in P/V ratio will mean more profit
– reduce variable cost
– increase selling price
– product mix to change in favour of high P/V
ratio products
– Change in FC?
 Assumptions
• Volume is the revenue and cost driver
• Total cost can be segregated into fixed and variable
components
• Total revenue and cost are linear functions of volume
within relevant range and time
• Selling price, VC per unit and fixed cost are known
and constant within relevant range and time
• Applicable to single product or multi-product situation
with constant sales mix as volume changes
 BEP- graphical method (CVP graph)
-shows how R & TC change when Q changes
Total sales
Total cost
Profit
Angle of incidence

BEP
Fixed cost
Rs. Loss

Units
 PV graph-
- shows how net income changes when Q changes

Profit
+
Profit
O
Loss BEP
Fixed cost -

Output volume
 Stimulate your thought
• What is margin of safety’s significance?
• MOS v. size of fixed cost: risk
• Larger angle of incidence: what does it imply?
• BEP point shift – up and down: what does it
mean?
• Monopoly- plant efficiency v. angle of incidence
• Competition- plant efficiency v. angle of
incidence
 Target operating income
Means a target contribution margin
Q = [Fixed cost + Target OI] / CMU
Understanding impact of IT:
Target net income:
= Target OI- Target OI X Tax rate
So, Target OI = Target NI / [1 – tax rate]
Hence, Q = [FC + Target NI / [1 – tax rate]]
/CMU
 Improving MOS
• Reduce FC
• Increase sales volume
• Selling more profitable products
• Reduce VC
• Increase in selling price in case of demand
inelastic products
 Sensitivity analysis

Revenue required at Rs.200 selling

price to earn the target OI of
FC VCU 0 1200 1600 2000
2000 100 4000 6400 7200 8000
120 5000 8000 9000 10000
150 8000 12800 14400 16000
2400 100 4800 7200 8000 8800
120 6000 9000 10000 11000
150 9600 14400 16000 17600
2800 100 5600 8000 8800 9600
120 7000 10000 11000 12000
150 11200 16000 17600 19200
A way to recognise uncertainty
 Cost planning & CVP
Revenue required at Rs.200 selling
price to earn the target OI of
FC VCU 0 1200 1600 2000
2000 120 5000 8000 9000 10000
2800 100 5600 8000 8800 9600

- Substitution of fixed cost for VC results in more risk of

loss (higher BEP) but offers a greater profit as revenue
increases.
Learning:
CVP analysis helps in evaluating various FC/VC structures
 Operating leverage
- Marry wants to sell 40 units @Rs.200/unit with
purchase cost of Rs.120/unit
Cost options:
Option-I Option-II Option-III
Rs.2000 FC Rs.800 FC + 15% of Revenue 25% of Revenue
OI: Rs.1200 Rs.1200 Rs.1200
BEP: 25 units 16 units 0 units
MOS= 15 units 24 units 40 units
If no. of units sold drops to 20 units: option I will give operating loss.
If no. of units sold is 60, option I will give highest OI of Rs.2800.
Cont…….
Learning:
Moving from I to III: Marry faces less risk of loss
when demand is low, but looses opportunity for
higher OI when demand is high.

Choice of cost structure: confidence in demand

projection and ability to bear loss

- Operating leverage measures this risk-return

trade-off
Cont……..

- Operating leverage describes the effects that

fixed costs have on changes in OI as changes in
sales volume happens, and, hence in
contribution margin.
- High FC and lower VC means, higher operating
leverage: small increase in sales results in large
increase in OI and small decrease means large
decrease in OI leading to greater risk of
operating loss.
- At a given level of sales: degree of operating
leverage = contribution margin / operating
income
Cont…..
Option-I Option-II Option-III
1. CMU Rs.80 Rs.50 Rs.30
2. CM Rs.3200 Rs.2000 Rs.1200
3. OI Rs.1200 Rs.1200 Rs.1200
Degree of
Operating leverage 2.67 1.67 1.00
[DOL]

DOL is specific to a given level of sales as starting point. If the

starting point changes, DOL changes

Interpretation: Change of sales by 50% would change the OI

under option-I by 50% X 2.67, i.e., by 133%
 Concept in action
Influencing cost structures to manage the risk-return
trade-off at amazon.com
- Amazon.com- virtual model- no warehousing and
inventory cost, but cost of books is high
- Barnes & Noble- brick & mortar model-
purchased from publishers with lower cost- high
fixed cost
- Amazon went for acquisition of distribution
centres (increased FC, Operating Leverage, risk,
but lower VC)
 Effect of time
Whether a cost is fixed or not, depends on:
1. Relevant range
2. Time horizon
3. Decision in hand
 Limiting Factor
- Constraints

- Contribution per unit of the limiting factor

- Multiple limiting factors

Contribution margin v. gross margin
Contribution income Gross margin income
statement statement
Revenues 100 Revenues 100
VC of goods sold 60 Cost of goods sold 60
Variable operating Gross margin 40
Cost 15 Operating cost[15+5] 20
Contribution margin 25 Operating income 20
Less: FC 5
Operating income 20
 CVP Analysis for ABC
Find out cost drivers for batch level FC and
on the basis of batch size relate it to product
VC. So, FC reduces, MCU also changes.
New BEP is arrived at.