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Cost-Volume-Profit Analysis

Presented by: Shaheen Shad Roll#: AM552069

Cost-Volume-Profit Analysis
CVP analysis shows the relationship between costs (both variable and fixed), volume (the number of units produced and sold), and profit or loss.

CVP is a useful management tool

CVP

it allows managers to understand and predict how changes in sales prices, sales volumes, and expenses will affect an organization’s profitability.

Cost-Volume-Profit Analysis
CVP analysis is an examination of the relationships of prices, costs, volume, and mix of products. It involves the separation of costs into their variable and fixed categories at the outset of the analysis.

Assumptions of CVP
 Revenues and costs are linear throughout the relevant range.  Costs can be identified as either fixed or variable.  Changes in activity levels are the only factors affecting

costs.
 The number of units produced and sold is the same.  In companies with more than one product, the sales mix is constant.

• If worker productivity changes as activity levels change. then variable costs per unit are not constant. • Linear total costs means total fixed costs are constant and variable costs per unit are constant. then variable costs per unit are not constant. . • If volume discounts are received from suppliers.Assumptions in CVP Analysis CVP analysis assumes that costs and revenues are linear within a relevant range of activity. • Offering volume discounts to customers violates this assumption. • Linear total revenues means that selling prices per unit are constant and the sales mix does not change.

can be used to estimate nonlinear cost and revenue functions.Assumptions in CVP Analysis • These assumptions may induce a small relevant range. . regression analysis. along with nonlinear transformations of the data. • Nonlinear analysis techniques are available. • For example. • Linear CVP analysis may be inappropriate if the linearity assumptions hold only over small ranges of activity. • Results of CVP calculations must be checked to see if they fall within the relevant range.

the company will determine how it will affect cost . CVP analysis . selling price and the output . For example if a company sell 2000 and wish to expand into foreign market .helps firms to know how total revenue and total cost can affect output level . How many new products that will be produced to breakeven It helps companies to better understand manufacturing cost .Cost-Volume-Profit Analysis The CVP helps companies to determine the following .

. both in units and in sales dollars: • The volume required to achieve target profit levels • The volume required to break even • The effects of discretionary expenditures •The selling price or costs required to achieve target volume levels • CVP analysis helps analyze the sensitivity of profits to changes in selling prices.How is CVP is Used CVP analysis can determine. costs. volume and sales mix.

or services we offer operating leverage. which compares the profitability of different products. which tells us the sales volume our need to break even. which magnifies our profits as sales increase. under different price or cost scenarios contribution margin analysis. . lines. which examines the degree to which our business uses fixed costs. but also magnifies our losses as sales drop.Cost-Volume-Profit Analysis There are three main tools offered by CVP analysis: breakeven analysis.

Variable cost CM may be shown as a per unit amount or a total amount at a specific level of sales. The contribution margin may be expressed as a per unit amount or as a total amount. The contribution margin is the amount available to cover fixed costs (below the break even point) and the amount to add to profit (above the break even point). CM = Selling price .Contribution Margins contribution margin is simply the percentage of each sales dollar that remains after the variable costs are subtracted. .

•The contribution margin ratio is usually expressed as a percentage. CM Ratio= Contribution Margin Sales .Contribution Margin Ratio •CMR = Contribution margin / selling price •The contribution margin ratio is the percent of each sales dollar that is available to cover fixed costs (below the break even point) and the amount to add to profit (above the break even point).

What is the break-even point? Revenues = Costs Break-even .

Demand is usually tougher to estimate. • Breakeven gives you a way to attack uncertainty. you can then fairly simply find the demand you must have to make the project a reasonable undertaking. costs. there are always variables to be considered: demand. By deciding that profit must at least be zero. only two missing variables remain profit (or cash flow) and demand. and miscellaneous factors. . price. In deciding whether to go ahead or to skip it. (the break even point). Profit comes after the breakeven point. • When most expenses can be determined. • A break even analysis is a management control tool that approximates how much you must sell in order to cover your costs with NO profit and NO loss.Uses of Break Even Analysis • It serves as a substitute for estimating an unknown factor in making project decisions. to get onto the target if not the bull's-eye.

• It's a cheap screening device. .• It enables you to determine with great accuracy whether or not your idea is a profitable one. Costs obviously affect price and marketing feasibility. Each design has implications for cost. Discounted cash flow techniques require large amounts of expensive-to-get data. Break even analysis can tell you whether or not it's worthwhile to do more intensive (costly) analysis. Best of all. It helps the management that at current costs of products how many numbers of units must be sold to at least recover the cost of producing the product. • Breakeven analysis allows the firm to determine at what level of operations it will break even (earn zero profit) and to explore the relationship between volume. • It provides a handle for designing product specifications. you can use this tool to evaluate every product or service you offer. Breakeven permits comparison of possible designs before the specifications are frozen. and profits. costs.

the sales mix is constant). .. costs only) analysis. at least in the range of likely quantities of sales.e.. an increase in the scale of production is likely to cause fixed costs to rise.e. • In multi-product companies. (i. it assumes that the relative proportions of each product sold and produced are constant (i. • It assumes that fixed costs (FC) are constant.e. as it tells you nothing about what sales are actually likely to be for the product at these various prices. this is true in the short run.The following are the limitations of a Break-even analysis • Break-even analysis is only a supply side (i. Although.e. • It assumes average variable costs are constant per unit of output. there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period). linearity) • It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.

• Breakeven Sales Volume = Fixed Costs divided by Contribution Margin Ratio. • Sales Price per Unit — Variable Costs per Unit = Contribution Margin per Unit.Breakeven Analysis • A tool for management decision making • breakeven point can be determined by using the following formulas: • Contribution Margin per Unit divided by Sales Price per Unit = Contribution Margin Ratio. .

The variable costs per briefcase are $80. Find the BEP in units and in sales $ for this company.000   3. and the total fixed costs are $360.000.000 BEP in units   P  V $200 / unit  $80 / unit $360.000   (P  V ) / P ($200  $80) / $200 .000 units $120 / unit BEP in Sales $ = F+0 CMR F $360.Break-Even Point Calculation Lets Mr Ali’s Briefcases makes high quality cases for laptops that sell for $200. F 0 $360.

Volume in Units . Costs and Revenue in Dollars Total fixed costs Total costs Draw the total cost line with a slope equal to the unit variable cost.Preparing a CVP Chart  Plot total fixed costs on the vertical axis.

draw the sales line with a slope equal to the unit sales price. Sales Costs and Revenue in Dollars Total fixed costs Total costs Breakeven Point Volume in Units .Preparing a CVP Chart Starting at the origin.

Units needed to F  Profit $360.000.000  5. CVP Calculations .000? What level of sales revenue is this? Recall that P = $200. 5.000. so this is still a valuable formula. V = $80.000 60% units x $200/unit = $1.000  $240.000 F  to reach target  CMR (P  V ) / P pretax profit $600.000.000. and F = $360.000 units Sales $ required F  $240.000   $1.000 reach target  P  V  $120 / unit pretax profit Of course. But sometimes you only know the CMR and not the selling price per unit. too.How many briefcases does Ali need to sell to reach a target pretax profit of $240.

000  $456.800 units reach target $120 / unit pretax profit Sales $ needed to reach target pretax profit $360. V = $80.000   6.CVP Calculations How many briefcases does Ali need to sell to reach a target after-tax profit of $319.200 if the tax rate is 30%? What level of sales revenue is this? Recall that P = $200.000 60% . First convert the target after-tax profit to its target pretax profit: After-tax profit $319.000  $456.200 Pretax profit    $456.3) Units needed to $360. and F = $360.000   $1.000.360.000 (1  Tax rate) (1  0.

Recall that F = $360.000 units V  $75/unit If Ali can reduce his variable costs to $75/unit. Determine the highest level that his variable costs can so that he can make his target.000  $170/unit  V $360. .000 briefcases if the selling price is reduced to $170. Use the CVP formula for units.Using CVP to Determine Target Cost Levels Suppose that Ali’s marketing department says that he can sell 6.000.000 units $360. he can meet his goal. Ali’s target pretax profit is $210. but solve for V: Q = 6.000  $210.000 $170/unit  V   $95/unit 6.000  $210.000.

• broad advertising campaign with higher selling prices vs. • High salary/low commission vs. lower technology process with higher variable costs per unit and lower fixed costs. . lower salary/higher commission for sales persons • highly automated production process with low variable costs per unit vs. minimal advertising and lower selling prices • The indifference point between alternatives is the level of sales (in units or sales $) where the profits of the alternatives are equal.Using CVP to Compare Alternatives CVP analysis can compare alternative cost structures or selling prices.

000) and earn a 5% commission on each unit ($10 per briefcase).$45.000 .000 and the commission is increased to 20% ($40 per briefcase).000 needed to  Q  F  0   3.Using CVP to Compare Alternatives Currently Ali’s salespersons have salaries totaling $80.$110/unit P V breakeven .000 V = $80 + $30 increase in commission = $110 Then compute Q under the proposed plan: Units $315. First compute F and V under the proposed plan: F = $360. He is considering an alternative compensation arrangement where the salaries are decreased to $35.000 decrease in salaries = $315. Compute the BEP in units under the proposed alternative.000 (included in F of $360. Recall that P = $200 and V = $80 currently.500 units $200 / unit .

for which Ali is indifferent between the two alternatives.000 Q = 1.000 $90 $315.000 $30Q = $45.$315. The indifference point in units is the Q for which the profit equations of the two alternatives are equal.Determining the Indifference Point Compute the volume of sales. in units.$315. Current Plan Proposed Plan Contribution margin per unit Total fixed costs $120 $360.000 $120Q .000 Profit (proposed plan) = $90Q .000 = $90Q .$360.500 units .$360.000 Profit (current plan) = $120Q .

BEP for the current plan TR TC-proposed plan TC-current plan $600 BEP for the proposed plan indifference point between the plans 1500 3000 3500 $1000s $360 $315 units . but the total cost lines are different.CVP Graphs of the Indifference Point Draw a CVP graph for Ali’s that displays the costs under both alternatives. Notice that the total revenue line for both alternatives is the same.

TR $1000s TC-proposed plan TC-current plan $600 $360 $315 Each unit sold provides a larger contribution to profits under the current plan. 1500 3000 3500 units . the plans have the same total cost.Comparing Alternatives The current plan breaks even before the proposed plan. At 1500 units.

. • Therefore. . However. it seems the current plan is preferable to the proposed plan. .Uncertainties in Ali’s Decision • Hopefully Ali is currently selling more than 1500 briefcases. because profits are negative under BOTH plans at this point. • The total costs of the current plan are less than the those of the proposed plan at sales levels past 1500 briefcases. .

this may not be true because the level of future sales is always uncertain. . • Salespersons may have an incentive to sell more units under the proposed plan. . • The plans may create different estimates of the likelihood of various sales levels. . • The lower fixed costs of the proposed plan may be safer. • What if the briefcases were a new product line? • Estimates of sales levels may be highly uncertain.Uncertainties in Ali’s Decision .

CVP Analysis for Multiple Products When a company sells more than one product the CVP calculations must be adjusted for the sales mix. • of total revenues when performing CVP calculations in sales $. . The sales mix should be stated as a proportion • of total units sold when performing CVP calculations for in units.

margin of safety in units margin of safety in $ margin of safety percentage = actual or estimated units of activity – BEP in units actual or estimated sales $ – BEP in sales $ Margin of safety in units Actual or estimated units = = . or plans to operate.Margin of Safety The margin of safety is a measure of how far past the breakeven point a company is operating. It can be measured 3 ways.

000 = = 40% 5.000.000 .000 units.000 units $400. margin of safety in units = 5.000.Margin of Safety Suppose that Ali’s Briefcases has budgeted next year’s sales at 5.000. F = $360.000 units margin of safety in $ = $200 x 5. Compute all three measures of the margin of safety for Bill. Recall that P = $200. .000 margin of safety percentage = 2.000 units – 3.000 The margin of safety tells Ali how far sales can decrease before profits go to zero.000 units = 2. the BEP in units = 3.000 units $200 x 5. V = $80.$600.000 = $400. and the BEP in sales $ = $600.

• A high degree of operating leverage indicates a high proportion of fixed costs. • but enjoy profits that rise more quickly when sales increase.Degree of Operating Leverage • The degree of operating leverage measures the extent to which the cost function is comprised of fixed costs. . • Businesses operating at a high degree of operating leverage • face higher risk of loss when sales decrease.

Degree of Operating Leverage The degree of operating leverage can be computed 3 ways. Contribution margin Profit degree of operating leverage 1 Margin of safety percentage Unit Contribution Margin = Sales Price .Variable Costs (Contribution /sales)*100 = this gives us profit volume ratio. = Fixed costs +1 Profit .

000 units: Contribution margin = ($200 .5 $240. First.5 $240.000 + 1 = 2.000. degree of operating leverage = $600.5 40% or. compute contribution margin and profit at 5.000 Profit = $600.000 Degree of operating leverage = or.$360.000 = $240.000 = $600. Compute Ali’s degree of operating leverage.000 = 2.000 $360.000 units is 40%. Recall that P = $200.000 1 = 2. F = $360.Degree of Operating Leverage Suppose that Ali’s Briefcases has budgeted next year’s sales at 5.000 .$80) x 5.000 units. V = $80. and the margin of safety percentage at 5. degree of operating leverage = .

I have contacted Tauqir Akhtar. . I will be discussing the company as well as its marketable securities in my research report. Muhammad Rashid HussainManager Finance and have researched several previous reports on PEL.Pak Electron Limited commonly known as PEL is an electronic company that produces electronic goods in Pakistan. Gulzaib Mohy ud din-HR Executive.

DATA COLLECTION METHODS Several ways for data collection were adopted to gather such information about PEL. 1. Communicating via Email Hiring Procedures Hiring System – Team / Panel designation for hiring people Structured interview Unstructured interview Behavioral interview . Primary Data (Tauqir Akhtar. Muhammad Rashid Hussain-Manager Finance) a. Gulzaib Mohy ud din-HR Executive.

Strengths Strong management team Distribution of authority Research and Development department Strategic Partners with LG Strong dealer Network Quality products Best sales services Weaknesses Financial Problems Lack of Advertisement System variations Lack of Product Range Less Utilization of Capacity Opportunities Rebuilding Projects Partnership with LG Exploration of Market in Pakistan Increase in Product range Export Quality Increase in Product Capacity Threats Strong Competition Introduction of China’s Products in the Market Price War Slow Growth rate in Pakistan Instability of Government .

PEL should try to capture the remove area market especially in Rural areas. To make their products technically round they need more technology advancement especially after failure of their TV in market. More innovative & new technology is needed.CONCLUSION PEL should concentrate on promotion of their products and try to enhance the Target Market of split. . and aggressive marketing activities to create awareness among public regarding their appliances product. To get more market share it needs qualitative products with innovative styles. More attractive Incentives should be designed to get more dealers interest in their products.

•Allocate more budgets to the marketing department. •More focus on PULL strategy in its promotion mix. •Focus on direct selling of its products to its customers. •The company should have a strong marketing information system to make proper forecasts. . •Should constantly add technology in its products and systems. Speed up delivery process by establishing/expanding its stores in areas of high demand.Recommendations •Adopt a true decentralized organization setup which gives all employees to take part in decision making. •Shorten the cash conversion cycle. •The company should announce two holidays in a week to improve the labor productivity level. •Make sure that the HR department is functioning properly.

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