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# CHAPTER 12

## Copyright 2009 Macmillan Publishers India Ltd, All rights reserved.

Cost-Volume-Profit Analysis

CVP analysis is a study of the relationships between a businesss costs, volume and their impact on profit.

Analyses the interplay of various factors that affect profits. An important part of the budgeting activities. Assists management in effectively utilising the fixed resources in the short run. Is a tool used in both the planning and control functions. Used to measure the performance of the different departments in a company. Is static as it is based on a given set of factors. Basic application of CVP analysis is the break-even analysis.

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## CVP Analysis helps the manager to solve following Questions :-

Q 1: How many units must be sold to break-even? Q 2: How will the break-even point change if additional fixed costs are incurred? Q 3: How will profits be impacted if price changes? Q 4: What is the break-even point for a desired level of profit?

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## Importance of CVP Analysis

CVP Analysis is useful to find :

## Sales volume required to produce desired profits

Minimum level of sales needed to avoid losses

## Effect on profits of changes in fixed costs and variable costs

Change in sales mix and its effect on profits

## The most profitable product

Effect of a simulation change in prices, costs and volume on profits

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Break-even Analysis

The break-even analysis is conducted by organisations to identify the level of operations at which the entity has covered all costs but has not earned any profits.

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Break-even Point

The break-even point is that volume of activity at which total revenue equals the sum of all variable and fixed costs. It can be computed both algebraically and graphically. It is expressed in either units of output or sales rupees. Charts can also be used to illustrate the break-even point. Fixed Costs B.E. Point (in Units) = Unit Contribution Margin AND Fixed Costs B.E. Point (in Sales Rs) = Contribution Margin Expressed as a percentage of Sales Revenue

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Contribution Margin

Contribution margin (CM) is the amount of revenue in excess of variable costs and contributes towards the fixed cost and profit of the company.

It is the difference between selling price per unit and the variable cost per unit CM provides the operating profit for the company

Contribution Margin Ratio (CM) Sales- Variable Costs CM = Sales CM (in units) = SP- VC
Where ,SP = Sales Price per Unit VC = Variable Cost per Unit

CM (In Percentage) =

## Sales VC x 100 Sales

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Example

Online Company manufactures and sells a single product called SPARK. The following financial projections have been made for the product: Unit SP Unit VC Unit Contribution Margin = Rs 25 = Rs 15 = Rs 10

The total fixed costs for the company are Rs 30,000. Presently, the sales of the company are Rs 1,00,000. How many units must be sold by the company to break-even? Also calculate the break-even point for the company in rupees.

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Solution:

## Assumptions underlying CVP Analysis

All costs can be classified into two types: fixed costs and variable costs. The total fixed cost remains constant with changes in sales volume for the time period being examined.

The total variable cost per unit is constant for the time period being examined but the total variable cost changes in direct proportion to sales volume.

Selling price per unit remains constant, i.e. it does not change with volume or because of other factors for the time period being examined.

Sales mix does not change if there are multiple products or the firm manufactures only one product.

## The productivity remains constant.

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Profit Planning

Profit planning is an extension of B.E Analysis This technique helps to find the sales (in units/ in Rs) to achieve a target profit
Fixed Costs+ Desired Profits Contribution Margin Per Unit Fixed Costs + Desired Profit CM Expressed as a Percentage of Sales Revenue

## BE Point ( in Sales Rs) =

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Profit Planning
Example:Fixed cost = Rs. 30,000/Contribution Margin = Rs.10/unit Contribution Margin as % of sales = 40% Desired profit = Rs. 10,000 Find out the BEP in units and in sales Rs.

## Solution:30,000 + 10,000 BE Point ( in Sales Units)= = 4000 units

10 30,000 + 10,000
BE Point ( in Sales Rs) = 0.4 = 1, 00,000

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## The Break-Even Graph

125
Total Revenue Line

## 100 Cost and Revenue (Rs thousands omitted)

Profit

75
Total Total Cost Line Variable Cost Break-even Point Fixed Cost Line Total Fixed Cost

50
Loss

25

## Units Sold (in Thousands)

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The Profit-Volume Graph (P/V Graph) The profit-volume graph shows a direct relationship between sales and profits and is easy to understand.
Loss (Rs) Profit (Rs) Thousands omitted

30 __ 20 __
Profit Area

10 __
0 __ 10 __ 20 __ 30 __

Break-even Point

Loss Area

## Units Sold (in thousands)

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P/V Ratio

When contribution margin expressed as a percentage of sales, it is called Profit Volume Ratio. The P/V Ratio is calculated as :

P/V Ratio =

Fixed Expenses

## B.E.P through P/V Ratio =

P/V Ratio

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Example:

P/V Ratio
= Rs 25 = Rs 15 = Rs 10

Online Company manufactures and sells a single product called SPARK. The following financial projections have been made for the product:
Unit SP Unit VC Unit Contribution Margin

The total fixed costs for the company are Rs 30,000. Presently, the sales of the company are Rs 1,00,000. How many units must be sold by the company to break-even? Also calculate the break-even point for the company in rupees.

Solution:

= 40%

= 0.4

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## Margin of Safety (M/S)

The

difference between the actual sales volume and the break-even sales volume is called the margin of safety (M/S).

It represents that proportion of the current sale which determines the profit of the firm.

## The M/S ratio is calculated as:

Sales- B E Sales 1,00,000 75,000

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M/S Ratio =
Sales

= 25%
1,00,000

= 2.5

## Limitations of CVP Analysis

The assumptions imposed by accountants in calculating the CVP ratios also serve as the possible limitations of the technique. Most CVP analyses are based on the concept of static or fixed cost.

Semi-variable costs also affect the cost composition. Fixed costs will not change at all levels of sales within the assumed relevant range at activity. Selling price per unit remains constant. Variable costs vary in direct proportion to changes in activity, i.e. as a percentage of sales revenue they remain constant. The sales mix is assumed to remain constant if more than one product is sold. The projections are over a short period of time only.

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## Problem and Solution of Cost-VolumeProfit and Break-Even Analysis :

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Problem I:
The following information pertains to the half year ending 30 June 2006 of a company:
Fixed Expenses 30,000 Sales Value 1,20,000 Profit 30,000 The company has projected a loss of Rs 6,000 for the second half of the same year ending 31 December 2006. (a) Calculate the break-even point, P/V ratio and margin of safety for six months ending 30th June 2006. (b) If the selling price and fixed expenses remain unchanged in the second half of the year, what is the expected sales volume for the second half? (c) Calculate the break-even point and margin of safety for the whole year.

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Solution I:
(a) P/V Ratio = (Contribution / Sales) X 100 = (Fixed Expenses + Profit) 100/ Sales Value = (60 000/ 1,20,000) 100 = 50% BE Point = Fixed Expenses / P/V Ratio = 30 000 / 50% = Rs 60,000 Margin of Safety = Sales BEP = 1,20,000 60,000 = Rs 60,000 (b) Contribution = Fixed Expenses Loss = 30,000 6,000 = Rs 24,000 Contribution = Sales x P/V Ratio = 24,000 = Sales 50% or Sales = Rs 48,000 for second half year. (c) For Full Year : Sales = 1,20,000 + 48,000 = Rs 1,68,000 Fixed Expenses = 30,000 + 30,000 = Rs. 60,000 P/V Ratio = 50% Profit = 30,000-6,000 = Rs 24,000 Break-Even Point = 60,000 / 50% = Rs. 1,20,000 Margin of Safety = 1,68,000 1,20,000 = Rs 48,000

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Problem II:
Following is the data for a company for the year 2007. Variable Costs per Unit:
Particulars Direct Materials Direct Labour Factory Overhead Total Fixed Costs: Factory Overhead Other Fixed Costs Selling Price per Unit Rs. 2,000 800 1,400 1,95,000 1,23,000 9,500

## (a) (b) (c) (d)

Compute the break-even point in units. If the company sold 70 units in 2007, how much profit did the firm realise? How many units should the company sell to generate a profit of Rs 84,800? Calculate net income if the company increases the number of units sold by 20 percent and reduces the selling price by Rs 500 per unit.

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Solution II:

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Problem III:
The Panasonic Company produces and sells a single product with the following costs and revenues for the year:
Particulars Total Revenues Total Fixed Costs Total Variable Costs Units Produced and Sold Units Rs. 5,00,000 1,00,000 2,00,000 1,00,000

## (a) (b) (c) (d) (e)

What is the selling price per unit? What is the variable cost per unit? What is the contribution margin per unit? What is the break-even point? How many units should be produced by the company to produce a profit of Rs 2,50,000 for the year?

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Solution III:

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