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Cost-Volume-Profit Analysis

‡ CVP Analysis is the analysis of the relationship between costs and profits at different volumes of output ‡ The main concept used in the CVP Analysis is the Breakeven analysis

Break even indicates the number of units to be produced and sold so that the company breaks even, i.e., the company neither makes a profit nor incurs a loss. A BreakEven Chart is a pictorial representation of the cost-volume-profit relationship. It is a graph showing the amounts of fixed and variable costs and the sales revenue at different volumes of operation. It shows the volume at which the firm just covers all costs, i.e., breaks even.

‡ Draw a horizontal OX-axis measuring Output and OYaxis representing Costs and Revenues. ‡ Draw the Revenue curve which starts from point O upwards. After drawing the Revenue curve draw the Variable. we have to follow the following steps. Variable cost line is drawn from O and it has upward sloping as Variable cost increases proportionately as output increases. whatever be the level of production.To draw a Break Even Chart. Fixed cost line is drawn parallel to X-axis as Fixed Cost remains the same. Fixed and Total Cost curves. Then the Total cost line is drawn from Fixed Cost Point and then the line runs parallel to the Variable Cost line. .

point) or loss (below B. ‡ . by raising the selling price or/and by reducing variable costs. Bigger the angle higher will be the profitability and vice-versa.‡ The point at which the Total Cost line cuts across the Total Revenue line is Break-Even point and volume. Angle of incidence: The angle of Total Revenue line to the Total Cost line at the B.E.E. A narrow angle of incidence reflects relatively low rate of profits. To improve this angle Contribution should be increased either. Point).E. point is known as ³Angle of incidence´. The spread between these two lines is either profit (above B.

we will now draw a Breakeven chart showing the break even point from the following data Budgeted output .Rs. 10 Selling Price per Unit . 4.Rs.Rs.000 units Fixed Expenses .00. 20 .000 Variable Cost per Unit .‡ ‡ ‡ ‡ To illustrate.80.

00.000 4.000 8.000 4.000 40.00.00.000 4.) Total Cost (Rs.) @ Rs.00.000 8.000 8.00.00.00.000 4.000 12.000 60.000 16.00.000 2.000 10.00.000 4.) Total Revenue (Rs.) Fixed Cost (Rs.000 20.00.000 . 20 P.000 6.00.00.00.U 4.Solution: Total Cost and Total Revenue for varying levels of output : Output (Units) Variable Cost (Rs.000 6.000 12.00.00.00.000 80.

Rs. Variable Cost line starts from point O and runs upwards as it varies directly with the level of units produced. 4 lakhs on Y-axis and runs upwards parallel to the Variable Cost line. Total Revenue line is drawn originating from point O. .e. i.Fixed Cost line runs parallel to X-axis as these costs are fixed for any level of production. Total cost line is drawn from Fixed Cost Point..

‡ Refer word document for graph .

e. Sales Formula is M/S = Actual Sales ± Break Even Sales .E.Graphically.P. i. now we can say that B.000 Margin of safety (M/S) is calculated as the excess of actual sales over the B.00. Rs.8. P. is at 40.000 units.E.

Larger the margin of safety.E. Margin of Safety for the above data is as follows M/S = Sales ± B. stronger are the prospects of the business and vice-versa.000 = 40. It can be improved by: i) reducing costs.000 ± 40.000 units . It indicates profit earning capacity of the concern. volume = 80. (ii) increasing sales revenues by raising prices or sales promotion activities or (iii) by changing over to more profitable lines.

Total Revenue (TR) = Total Cost (TC) (or) TR ± TC = 0 (SPp.We can also find the BEP mathematically. instead of graphically.u. To find the break even point mathematically we derive a formula for Break Even Point At BEP. is Variable Cost per unit . is Selling Price per unit Qp/s is Quantity Produced and Sold FC is Fixed Cost VCp.u.*Qp/s) ± (FC + VCp. * Qp/s) where SPp.u.u.

*Qp/s) ± FC ± (VCp. ± VCp.u.u.u. * Qp/s) = 0 (SPp.The above equation can also be written as (SPp.u. Qp/s * (SPp. * Qp/s) = FC Taking Qp/s as common.*Qp/s) ± (VCp.u.u.) = FC .

u.u.As. is Contribution per unit Therefore. BEP = FC/C p. is Contribution p. we can write the above equation as. ± VCp.e.. = FC Where Cp..u. Qp/s = FC/C p. Qp/s * Cp.u.u. SPp.u. i.u. .

.Thus. BEP in the above data can be calculated as follows BEP = 400000 / (20 ± 10) = 40000 units which is the same as the one we arrived at graphically.

000 Rs.75. 1.00.10) Rs.000 Overheads : Variable Rs.000 Find the BEP.75. 1.000 Material Costs Rs. . 1.00. 50.In framing the budget of your company.000 Fixed Rs. 5.25. the following forecasts have been made : Sales for a month (50000 units @ Rs. 1.000 Labour Rs.

Margin of Safety indicates profitability of a company. . Changes in costs and profits at changing volume of output can be readily understood. It is useful in forecasting cost. It facilitates cost control by showing deviation of actual performance or costs from planned or standard costs and hereby invites the attention of management to take appropriate decision.Uses of Break Even Analysis It depicts pictorially cost-volume-profit relationship. sales and profit and in operation of budgetary control. It demonstrates easily the effect of changes in price or in sales on profits.

varies in direct proportion to the volume. Variable cost per unit is constant and therefore. . Costs are either fixed or variable and they can be clearly separated. Selling price per unit remains unchanged. Production and sales during a period are equal with out any stock on hand.E. charts are constructed on certain unrealistic assumptions which are as follows.Limitations of Break Even Analysis B.

size of the concern. . for there is the problem of semi-variable costs . etc. etc.But these assumptions are not true in the real world. Therefore. the variable cost per unit may not remain constant but may reduce on account of economies of bulk buying. variable costs will not rise in exact direct proportion with the increase in output and variable cost line will bend towards X-axis. When production increase. Fixed costs do not remain same in the long run but change in response to technological development. because It is not possible to segregate costs into watertight compartments of fixed and variable ones.

. will have to be allowed to increase sales. B. Charts give rough idea of the problem as detailed information is not available from graphs. chart presents only cost volume profits but ignores other considerations such as capital amount. Charts give static picture of the situation. marketing aspects and effect of government policy etc. which are necessary in decision making. sales line too does not remain straight but will bend towards X ±axis. Therefore.Similarly. selling price does not remain same at higher level of production as more trade discounts etc.E. Sales and promotion can rarely be equal as there may generally be opening and closing stock of finished goods.

under marginal costing only Variable costs are considered in decision making. . Contribution Profit = Sales ± Variable Cost = Sales ± Variable Cost ± Fixed Cost = Contribution ± Fixed Cost Contribution is also known as gross margin or marginal income. as against Profit which is Sales minus Variable Cost minus Fixed Cost. Thus. marginal costing uses a concept called Contribution which is Sales minus Variable Costs. whereas variable costs change as the level of production changes. Therefore.ALTERNATIVE CHOICE PROBLEMS Usually in taking decisions regarding problems having alternative choices. So. Marginal Costing technique classifies costs into fixed and variable costs. This is crucial as fixed costs remain the same whatever be the level of production. the marginal costing technique is used.

to make or buy . which are incurred on time basis. It enables effective cost control by dividing costs into fixed costs and variable costs.Merits of Marginal Costing It assists in taking decision such as pricing. (as explained previously). This practice appears to be better than carrying a part of such fixed cost to next year by including it in the value of closing stock. accepting foreign orders at low price . change in market etc. There is no problem of arbitrary apportionment of fixed costs. Stock is valued at marginal cost and does not include fixed costs like rent. profitable product-mix. Marginal costing charges all fixed costs (which are mainly incurred on time basis and not related to production) to current year¶s profits. . It yields better results when used with standards costing. insurance etc.

The reports are based on figures of marginal costs and sales rather than on total cost and production. departments. productive facilities.Contribution analysis enables evaluation and comparison of profitability and efficiency of product lines. Marginal costing has a unique approach in reporting cost data to the management. sales divisions or of alternative policies and guides effectively in taking decisions. volume and profit by means of break-even charts aids in optimizing the level of activity and helps in profit planning. So fixed cost and stocks do not vitiate appraisal as well as comparison of profitability or performance efficiency. Differentiating fixed and variable costs and depicting the interrelationship between cost. .

If the amount of fixed costs of two firms differ. Sales revenue and variable costs do not increase in rigid proportion with the volume of production they are less proportionate than what they should be. It ignores time element as over a long period all costs (including fixed costs) change. Therefore. They are not considered in the analysis. Since variable overheads are apportioned on estimated basis problem of under or over recovery cannot be eliminated. There are Semi variable costs. Price fixation and comparison between two jobs cannot be done without considering fixed costs. the comparison of both the firms on the basis of contribution is likely to mislead. comparison of performance between two periods on the basis of contribution is not possible. This is due to trade discounts economics of bulk buying. .Limitations of Marginal Costing It is difficult to separate µFixed¶ and µVariable¶ costs clearly. concessions for higher sale etc.

Consequently profits are suppressed and the Balance Sheet is distorted. The firm may incur losses.Guided by marginal cost principle. In controlling costs. ignoring its plant capacity. It may necessitate overtime working. extension of production capacity which in turn may increase cost of production and bring change in fixed costs. Indiscriminate acceptance of orders at lower price may affect local market price. a firm may accept excessive orders at lower price. marginal costing is not useful in concerns where fixed costs are huge in relation to variable costs. Valuation of closing stock at marginal cost will lead to underestimating it in the final accounts. .

in case loss by fire. The concept of contribution is used in decision making involving alternative strategies. If fixed expenses are ignored in valuation of work-in-progress.It is found unsuitable in industries like ship building. Since stock is undervalued at marginal cost. where the value of work-in-progress is high in relation to turnover. contract etc. full loss cannot be recovered from insurance company. It may create income tax problems. . losses may occur every year till the contract is completed and on completion there may be huge profit.

parts or tools in its workshop or buy the same from outside. In this context. if the outside price is higher than the marginal costs. making in the factory may be preferred (assuming production capacity is available). the marginal costing directs that if the outside price of the components is lower than the marginal cost of producing it. It is for the management to choose the course keeping in view optimum utilization of its capacity. . On the other hand. it is worthwhile to buy.Make or Buy Decisions A factory may make certain components.

Give also your views in case the supplier reduce the price from Rs. 6.00 each the same is available in the market at Rs. The cost data is as follows : .60 to Rs. 5.An automobile manufacturing company finds that while the cost of making in its own workshop part no. 0028 is Rs. 5.60 with an assurance of continuous supply. Write a report to the Managing Director giving yours views whether to make or buy this part. 4.60.

50 0.Materials Direct labour Other variable costs Depreciation and other fixed costs Rs. 2.50 1.00 2.00 ====== .00 --------6.

the decision depends on the marginal cost of making the product. Buying should be preferred if the outside price is below marginal cost of the part as the difference between the two will be a net saving in marginal costs.Since fixed costs are to be incurred whether we manufacture or not. In this case the problem may be analysed as under: .

60 Profit Rs.60 5. Buying Price (Per Unit) 5.40 .60 Marginal cost (Per Unit) Material Rs.Rs. 0. 2. 4.50 Variable Costs Rs.00 Labour Rs.00 0.50 Loss 0. 2.

60 per unit. 5.‡ Therefore.60 it is advisable to buy at Rs. 4. it is better to make. . if the price quoted is Rs.

we can appreciate how costing techniques are applied in situations where alternative choices are available. The other situations where this technique of marginal costing can be applied are as follows.1) 2) 3) 4) 5) Thus. Own or Rent Retain or Replace Now or Later Change or Status Quo Slow or Fast .