BITS Pilani

presentation
BITS Pilani Krishna M
Economics and Finance
Pilani Campus

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 BITS Pilani
Pilani Campus

FIN ZC415 / MBA ZC415

Financial and Management Accounting
Lecture 9: Cost-volume Profit Analysis
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 Outline of the Presentation

Cost volume profit analysis

 Introduction to Cost Volume Profit Analysis

 Need for CVP analysis
 Algebra of CVP analysis
 Graphical representation
 Practice questions

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 Outline of the last lecture

Ratio Analysis

 Introduction to Ratio Analysis

 Introduction to financial ratio analysis
 Meaning and classification of ratios
 Liquidity ratios
 Solvency ratios
 Profitability ratios
 Turnover ratios
 Practice problems
 Calculation of the above ratios
 Preparation of Financial Statement using Ratios
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 Behavior of Costs
 Cost-volume relationships.
 How costs behave as the level of activity changes
 Types of costs
 Fixed (cost that do not vary, in total, at all with volume)
 Those costs may increase with time
 The amount of fixed cost per unit of activity decreases as volume
increases
 Variable costs (cost that vary, in total, directly and proportionately
with volume)
 Volume: number of outputs produced
 Semi-variable costs.
 Combination of variable-cost and fixed cost items
 It does not mean exactly
 The cost of operating an automobile is semi-variable with respect
to the number of miles driven.
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 Variable Costs

 Items of cost that vary, in total, directly and

proportionately with volume.
 Volume refers to activity level.
 Examples:
 Material costs varies with units sold.
 Electricity costs varies with production hours.
 Stationery and postage costs varies with number of
letters written.

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 Fixed costs

 Non-variable costs = items of cost that, in total,

do not vary at all with volume.
 Examples:
 Building rent, property taxes, management salaries.
 Fixed cost per unit of activity decreases as the level of
activity increases.
 For fixed costs, cost per unit is an average cost.
 Fixed costs are fixed for a range of activity and a limited
period of time.
 Fixed costs may change for reasons such as a deliberate
management decision to change them.

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 Cost-volume (C-V) diagram

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 Cost-volume (C-V) diagram

 Illustration in the above figure.

 Y or vertical axis reflects total cost.
 X or horizontal axis reflects volume.
 y = mx + b.
 y is the cost at a volume of x;
 m is the rate of cost change per unit of volume
change, or the slope (variable costs).
 b is the vertical intercept, which represents the fixed
cost component.

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 TC = TFC +(UVC*X)

 TC = total cost
 TFC = total fixed cost (per time period)
 UVC = Unit variable cost (per unit of volume)
 X = volume.
 Equations for:
 Variable cost line: TC = UVC*X
 Fixed cost line: TC = TFC
 Semi-variable cost: TC = TFC + (UVC*X), same as
above.

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 Cost Relations

 Average costs = total cost/volume.

 Average cost behaves differently than total cost.
 As volume goes up 
 Total fixed cost remains constant
 Total variable costs goes up
 Per unit variable costs stays the same
 Per unit fixed cost goes down
 Per unit total cost goes down.
 As volume increases without limit, unit cost approaches
variable unit cost and fixed cost per unit approaches zero.

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 Relation of Unit costs to volume

Our cost of producing and selling product X is $6 per unit. The question: at what volume is our unit
cost $6?
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 Limitations of C-V Relations

 A straight line approximates cost behavior only within a

certain range of volume, the relevant range.
 When volume approaches zero, management takes steps to
reduce fixed costs.
 When volume exceeds relevant range, fixed costs increase.

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 Relevant Range

$2,000 - Relevant range

Total cost:
TFC +
1,600 -
(UVC*X)
1,200 -
Cost

Variable
portion:
800 - (UVC*X)
UVC
400 -
Fixed
TFC
portion: TFC
0 -
50 100 150 200
250 Volume (X)

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 Limitations (continued)

 Relevant time period

 Amount of variable costs depends on the time period
over which behavior is estimated (the relevant time
period).
 If the time period is one day, few costs are variable.
 Over an extremely long time period, no costs are fixed.
 Environmental assumptions must be made.
 Wage rates, fringe benefits, material prices, technology
changes.

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 “Sticky” Costs

 What is it?
 Do not change.
 Generally considered variable but fall less with decreases
of activity than they rise with increases.
 Why it is sticky?
 Managers tend to increase resources more quickly when
volume increase than they reduce them when volume
decrease.
 Stickiness varies across companies
 Examples:
 Sales commissions with minimum guarantees.
 Managers slower to fire employees than to hire.

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 Linear Assumption

 C-V relationship is often not linear.

 Some items of costs may vary in steps
 Some cost functions are curved (curvilinear).
 Segments of the curve can be approximated by a straight
line, each with its own relevant range.
 Step function costs = items of cost vary in steps.

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 Step-Function Cost

Cost

Volume

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 Step-function costs

 Step-function costs
 Incurred when costs are added in discrete chunks, e.g., a
supervisor for every 10.
 Adding the “chunk”
 One supervisor for every additional 10 employees) of costs
increases capacity.
 Height of a stair step (riser) indicates
 The cost of adding incremental capacity.
 Step width (tread)
 It shows how much additional volume of that activity can be
serviced by this additional increment of capacity.

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 Step function (continued)

 If treads” are narrow and “risers” are low

 i.e., steps are small, then the steps can be approximated
by a variable cost line.
 If is believed within the relevant time period that
cost will remain within the relevant range for a
single stair step (tread), then the cost is
appropriately treated as a fixed cost for the time
period.
 Step functions are often hidden in C-V diagrams
as either variable or fixed costs.

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 Estimating the Cost-Volume Relationship30

How do I
estimate fixed
Four methods for
and variable cost? estimating total fixed cost
and unit variable cost

 Judgment
 High-low method
 Scatter diagram
 Linear regression

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 Estimating C-V Relationship

 Four methods
 1. Judgment or account-by-account method.
 Each account in cost structure is estimated and divided
between fixed and variable costs.
 2. Scatter diagram
 Plot a number of observations (perhaps prior period results)
of costs and volumes on a graph and visually draw a line of
best fit.
 3: High-low method
 4: Linear regression

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 Third method: High-Low Method

 Method
 Estimate total costs for two volume levels,
preferably one high level and one low level.
 To determine slope or variable cost per unit:
 Change in total cost between the two points divided by
change in units of output.
 To determine fixed costs:
 Subtract from total costs at either one of the points the
unit volume times the unit variable costs.

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 High-Low Method

Month Costs Volume

July $1,400 1,000
High August 1,700 1,100
month
September 1,500 900
October 1,300 800
November 1,500 1,200
December 1,300 700

High Cost - Low Cost

High Volume - Volume Cost

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 High-Low Method

Month Costs Volume

July $1,400 1,000
High August 1,700 1,100
month
September 1,500 900
October 1,300 800
November 1,500 1,200
December 1,300 700

$1,700 - Low Cost

1,100 - Volume Cost

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 High-Low Method

Month Costs Volume

July $1,400 1,000
August 1,700 1,100
September 1,500 900
October 1,300 800
Low
November 1,500 1,200
month December 1,300 700

$1,700 - Low Cost

1,100 - Volume Cost

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 High-Low Method

Month Costs Volume

July $1,400 1,000
August 1,700 1,100
September 1,500 900
October 1,300 800
Low
November 1,500 1,200
month December 1,300 700

$1,700 - $1,300 Variable

cost is $1
1,100 - 700 per unit

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 High-Low Method

Fixed Cost

Total Cost = Total Fixed Cost + Unit Variable Cost (X)

$1,700 = Total Fixed Cost + $1 (1,100)
$600 = Total Fixed Cost

Total cost in the Number of units

highest month at highest month

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 Fourth: Linear regression

 Use a statistical method of fitting a line to a

number of observations of volume and cost
(method of least squares or linear regression).
 Eliminate outliers, that is, unusual observations (e.g.,
period during which there was a strike).
 Assumes the future will be the same as the past (rarely a
completely accurate assumption).
 Scattergrams covering long periods of time may reflect
nothing more than price changes over the period (drift).

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 Measures of Volume

 Two questions
 Input (resources used) or output (goods or services
produced)?
 Money or non-monetary quantities?
 Have assumed a single-product.
 If multiple products, with different cost structures,
unlikely that units would be a reliable measure of
activity.
 Possible common denominators include:
 Labor hours, labor dollars, machine hours, homogeneous quantities
such as tons or barrels and sales value.

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 Input or Output?

 Input measures:
 Resources used:
 labor hours worked, labor cost, machine hours, kilowatt hours of
electricity, pounds of material.
 Output measures:
 Units or dollars.
 Manufacturing costs
 It might use input measures such as labor or machine hours.
 Retail stores
 It might use dollar sales.

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 Money or Non-monetary Quantities?

 A non-monetary measure
 It is not affected by price changes and therefore may have
some advantages.
 If price changes affect all costs equally, the use of labor
costs as an activity measure implicitly allows for price
changes.
 Best volume measure should be related to the activity
that causes the cost.
 The more items of cost that are combined in the cost
function the more difficult it is to relate the causality to
a single measure.

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 Profit-graph

 Add revenue line to C-V diagram.

 Assumes constant selling price.
 UR = unit revenue
 TR = total revenue
 UP = Selling price

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 Profitgraphs
Profit
Revenue
$2,000 -
Total Cost or Revenue
1,600 - Loss

1,200 -

800 - Cost
400 - Loss Profit
Zone Zone
0 -
50 100 150 200 250
Data Volume
Fixed costs (TFC) $400.00
Variable costs (UVC) $6.00 160 = breakeven
Selling price (UP) $8.50
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 Breakeven Volume

 Revenue (TR) at any volume (X) =

 TR = UR*X
 And cost (TC) at any volume (X) =
 TC = TFC + (UVC*X)
 Breakeven: TR = TC
 Break-even volume
 Substituting: UR*X = TFC + (UVC*X)  X = TFC/(UR -
UVC)
 X = $400 / ($8.50 – $6) = 160 Units

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 Schematic of Contribution
Revenues

UR

UR

C Contribution
C

Fixed Costs Profits

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 Unit Contribution

 Unit contribution
 = unit contribution margin
 = marginal income
 = unit selling price - variable cost per unit
 = UR - UVC.
 I = total income = (UR - UVC) * X - TFC.
 Implies that total income at any volume is unit
contribution (UR-UVC) times volume, minus fixed cost
 ($8.50 – $6)* $250 - $400 = $225
 What is contribution:
 First it is the contribution to cover fixed costs.
 Then it is the contribution toward profit.
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 Break-even Volume

 Break-even volume (Units)

 = Fixed costs / unit contribution
 Break-even volume (revenue dollars)
 = Fixed costs / contribution percent

 Contribution percent
 = contribution margin percentage
 = contribution as a percent of revenues
 = (UR - UVC)/ UR
 Each unit of revenue will produce 29.4 cents contribution
 ($8.5 – $6) /$8.5 = 29.4

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 Target Profit

 Calculate the volume necessary to earn a target profit

level.
 Add to breakeven analysis to show units or dollar of
sales to achieve a target (T) level of profit:

UR*X = TFC + (UVC*X) + T

X = (TFC+T) / (UR - UVC)

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 Target Profit

Target fixed costs + Target profit

X T
= Unit contribution margin
How many
$400 + $17,600 units do I have
X T
= $8.50 - $6.00 to sell to make
a $17,600 profit?

X T
= 7,200 units

Data
Fixed costs (TFC) $400.00
Variable costs (UVC) $6.00
Selling price (UP) $8.50
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 Target Profit with Taxes

 Add to breakeven analysis to show units or dollar of sales

to achieve a target level of profit after taxes (PAT):
(assume tax rate = TR)
UR*X = TFC + (UVC*X) + T
Need to convert PAT to T =>
T – (T*TR) = T * (1 – TR) = PAT =>
T = PAT/(1 – TR); thus
X = (TFC+[PAT/(1-TR)])/(UR - UVC)

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 Profit-graph Shows to Improve Profit
Performance:

 Increase selling price.

 Decrease variable cost.
 Decrease fixed cost.
 Increase volume.

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 Influences on Costs

 Changes in input prices.

 Rate at which volume changes.
 Rapid changes in volume make it more difficult to
change personnel costs, therefore, the more likely
costs depart from a straight line relationship.
 Direction of change in volume.
 Tends to be a lag in cost changes.
 Duration of change.
 Temporary changes affects costs less than a long term
change.

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 Influences on Costs (cont.)

 Prior knowledge of change allows planning for

change.
 As productivity changes costs change.
 Management discretion.
 Costs change because of management decisions.
 Learning curves.
 Productivity increases, i.e., unit production costs
decrease, as the company gains experience producing
the product.

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 Prevention and Appraisal Costs

Support activities whose

Prevention Costs purpose is to reduce the
number of defects

Incurred to identify
Appraisal Costs defective products before
the products are shipped

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 Internal and External Failure Costs

Incurred as a result of
Internal Failure
identifying defects before
Costs they are shipped

Incurred as a result of
External Failure
defective products being
Costs delivered to customers

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 Thank You

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