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Cost-Volume-Profit (CVP) Analysis

Cost volume-profit analysis basically identifies the relationship between those three terms. Use for profit planning process of the firm. Its most common application is break-even analysis.

Cost-Volume-Profit (CVP) Assumptions

All cost can be separated in to fixed and variable.

Total fixed cost does not change over the given volume range.

Per unit selling price and per unit variable cost do not change

In the multi product situations, sales mix of the products does not change.

Graphical Representation (Break Even Chart)

It is a diagrammatic presentation of the break even point, margin of safety and values of profits and losses at different levels of activity

Break even analysis highlights the concept of contribution.

Break-even analysis indicates the level of sales at which costs and revenue are in equilibrium.

Break-even point can be computed in terms of unit or in terms of monitory value of sales volume or as a percentage of capacity.

Full note set with Examples and Questions: http://www.executioncycle.lkblog.com/2012/06/my- business-economics-and-financial.html

The Profit/Volume Graph (P/V graph)

The P/V graph is another type of break-even chart which shows the profit or loss at different levels of activity, usually in terms of sales

The profit/loss at a given level of activity is shown clearly in this diagram which could be considered a further refinement of previous diagram

However variation of revenue and cost are lost sight of which is an inherent weakness in this graph

Contribution Margin (CM)

The CVP model can be re-written as

Profit (P) = Contribution [(p-v)x] Fixed Cost (f)

This equation implies that profit fluctuates with changes in contribution

Hence, profit is dependent on contribution

More specifically, profit is directly proportional to contribution

It is that level of activity (output or sales since production is assumed to equal sales) at which the firm neither enjoys any profit nor incurs any loss

That is the level of output whose contribution margin just covers the fixed costs

Beyond the break-even point every unit sold brings in contribution, which is termed profit

Full note set with Examples and Questions: http://www.executioncycle.lkblog.com/2012/06/my- business-economics-and-financial.html

Break even point (BEP)

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In order to find out the break-even point in revenue terms the break-even equation can be multiplied by the price per unit on both sides

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The BEP tends to increase with increase of fixed cost or variable cost per unit

Further BEP tends to decrease with the decrease of fixed costs or variable cost per unit or increase of selling price per unit

It is preferable for any organization to conduct its business with a low break-even point

The break even point (units or revenue ) is a very useful summary statistic of the three parameters

 o Price o Variable cost o Fixed cost

Which enables the manager to judge whether a given product line or entire production division will be profitable at a given level of activity or if not

Also when it will start generation profits

Margin of Safety (MS)

It is the excess of sales (assuming production equals sales) over the break-even level sales

It indicates the amount by which sales can drop before loss making will occur

MS (Rs) = Sales value BE sales

The margin of safety can also be expressed as a percentage

MS (%)

= MSx100/ Sales Value

It acts as a measure of safety towards a possible fluctuation of sales about the budget value

Margin of safety is the distance between the given level of activity and the break-even point

In P/V graph the margin of safety is the distance between the maximum given level of activity and the break even point

Safety of the firm depends on profitability. Profitability depends on margin of safety. Hire the margin of safety higher the profitability.

= 100

Full note set with Examples and Questions: http://www.executioncycle.lkblog.com/2012/06/my- business-economics-and-financial.html

Break Even Chart Uses

Determination of the break-even point and margin of safety

Estimation of profits associated with a given level of activity

Estimation of the level of activity at which a given profit/loss is recorded

Observation of the variation of costs and sales with level of activity

Break-even analysis under Multi-product situation

This example describe how we can do break-even analysis under multi-product situation

Limitations of CVP analysis

Sometimes it is difficult to separate cost in to fixed and variable components

Difficult to use break-even analysis for multi product firm.

This is a short run concept and limited use in long run planning.

Assumptions of constant selling price, unit variable cost and fixed cost is not valid

Full note set with Examples and Questions: http://www.executioncycle.lkblog.com/2012/06/my- business-economics-and-financial.html