MODULE 1- BASIC COST CONCEPTS

SUB MODULE 1.2

What went wrong with Coleco’s decision
to emphasize production of Adam
instead of Cabbage Patch Dolls?
 LEARNING OBJECTIVES

 Cost - Volume Relationships

 Cost Drives and Revenue Drives
 Break Even Point
 CVP –assumptions
 Role of Income Taxes in CVP Analysis
 PV Charts
COST-VOLUME-PROFIT
ANALYSIS

CVP analysis is based on an explicit model of

the relationship between the three factors –
costs, revenue and profits and how they
change in a predictable way as the volume
of activity changes

Blocher,Chen and Lin in Cost Management –

A strategic Emphasis
 CVP ANALYSIS

 Cost-volume-profit (CVP) analysis is a technique

that examines changes in profits in response to
changes in sales volumes, costs, and prices.
 It establishes the relationship between costs,
volume and profits.
 CVP analysis shows the relationship among the
various ingredients of profits planning namely
Unit sale price, Variable cost, sales volume, and
fixed cost.
 CVP ANALYSIS

 It is a powerful tool for planning of profits. It

provides an answer to “What if” theme.
 With a given change in costs and /or volume, what
is the expected change in profits?
 CVP techniques is based on cost behavior
patterns – how costs respond to changes in
output level.
 CVP ANALYSIS
CONTINUED……

Accountants often perform CVP analysis to plan future

levels of operating activity and provide information about:
 Which products or services to emphasize?
 The volume of sales needed to achieve a targeted level of
profit.
 The amount of revenue required to avoid losses.
 Whether to increase fixed costs.
 How much to budget for discretionary expenditures?
 Whether fixed costs expose the organization to an
unacceptable level of risk?
 APPROACHES TO CVP
ANALYSIS

 There are three approaches to CVP analysis:

 Equation Approach
 Contribution Margin
 Profit Graph
 EQUATION APPROACH

 Under this approach cost and revenue equation are used for CVP
analysis.
 Assuming liner relationship between the operating profit, revenue
and costs, the following relationship is drawn;
Operating Profit = Total Revenue – Total Cost
I = TR - TC
I = PX – (VX + F)
I = ( P – V)X - F
Where TR = PX (Price x volume of operation)
TC = VX + F (variable cost x volume of operation
+ Fixed cost)
The contribution margin (P-V) is the amount each unit sold
contributes towards
a. covering of fixed costs
b. providing operating profits.
 CONTRIBUTION MARGIN
APPROACH
 Contribution Margin is the excess of sales price of a unit of
output over its variable cost i.e. (S-V).
 It is the difference between the portion of rupees that is
left after variable expenses are deducted.
 Contribution = Selling Price – Variable cost
= Fixed Expenses + Profit
Contribution – Fixed Expenses = Profit/Loss
 Contribution margin approach is useful in determining the
break – even point and target profit.
 Contribution Margin(%) = Contribution per unit/ SP per unit
 Example COST CLASSIFICATION OF
of
Cost –Volume OWNING AND OPERATING A
Relationship
PASSENGER CAR
Cost Classification References Cost
Variable Costs:
Standard miles per gallon 20 miles/ gallon
Average fuel price per gallon $1.34/ gallon
Fuel and oil per mile $0.0689
Maintenance per mile $0.0360
Tires per mile $0.0141

Annual Fixed Costs:

Insurance:
Comprehensive $90
Collision $147
Body injury & Property damage $460
License & Registration $95
Property tax $272

Mixed Costs: Depreciation

Fixed portion per year $3,106
Variable portion per mile $0.04
 C-V RELATIONSHIP

Volume Index (miles) 5,000 10,000 15,000 20,000

Variable costs ($0.1190/mile) $595 $1,190 $1,785 $2,380

Mixed costs:
Variable portion 200 400 600 800
Fixed portion 3,106 3,106 3,106 3,106
Fixed costs: 1,064 1,064 1,064 1,064
Total variable cost 795 1,590 2,385 3,180
Total fixed cost 4,170 4,170 4,170 4,170
Total costs $4,965 $5,760 $6,555 $7,350
Cost per mile $0.9930 $0.5760 $0.4370 $0.3675
 COST DRIVES AND
REVENUE DRIVES

Cost Drives

 A cost driver is any activity that causes a

cost to be incurred.
 Cost driver is a cost accounting term.
 The cost driver for an activity is the factor
that influences the amount of the resources
that will be consumed by a particular activity.
 A cost driver is designed to allocate the
activity cost pool (or related costs) to the
cost objects.
1. The activity is the work that is done.
2. The resource is what the activity uses to do the work, i.e.,
people, equipment, services. Resources cost money.
3. The cost of the activity depends on the quantity of
resources used to accomplish the activity.
4) The cost object is what one wish to cost. It could be a
product, service, process, job or customer.
Example:
One part of the Ace Trucking's business operation involves
making deliveries by truck. The activity is delivering goods.
The costs of this activity include the truck drivers’ wages,
fuel, depreciation of the truck, insurance, etc. The quantity
of the resources that will be consumed by this activity are
influenced by the number of deliveries made per year.
Hence the cost driver could be the number of deliveries.
 REVENUE DRIVES

 Revenue drivers are defined as all areas of

revenue generation within the organization &
cost object.
 BREAK EVEN POINT

 Break Even point may be defined as a point at which

the firm’s total revenues are exactly equal to total
costs, yieding zero income.

 It is “no-profit, no-loss” point at which losses cease

and profits begin.

 It shows the relationship between the costs and

profits with sales volume.
METHODS OF
DETERMINING BEP

 BEP can be determined by two methods:

 Algebric Methods :
 ContributionMargin Approach
 Equation Technique

 Graphic Presentation:
 Break Even Chart and
 Profit Volume Graph
 ALGEBRIC APPROACH –
CONTRIBUTION MARGIN
APPROACH
•BEP (Units) = Fixed Cost / SP – Unit Variable Cost
Or
•BEP (Units) = Fixed Cost/ Contribution Margin (CM)per unit

•BEP(Amount) = Fixed Cost x Selling Price per unit

CM
Or
•BEP (Amount) = Fixed Cost/ PV Ratio

Where : PV Ratio = Contribution margin per unit/SP per unit.

PV Ratio = Change in contribution/change in sales
PV Ratio = Change in Profit /change sales
 MARGIN OF SAFETY

 The excess of Actual Sales Revenue over the Break Even

sales Revenue is known as the Margin of Safety.
Margin of Safety = Actual Sales Revenue –
Break Even Sales Revenue
 Actual
It indicates the percentage by which theSales
actual sales
may be reduced before they fall below the break even
Revenue
sales volume.
 Higher the margin of safety ratio, the better the firm
position.
 The amount of profit that can be determined with
reference to margin of safety and P/V ratio:
 Profit = MOS(amount) x P/V ratio
 Profit = MOS(Units) x CM per unit
 EXAMPLE:

 How many Ice-cream, having a unit cost of Rs. 2

and a selling price of Rs. 3, must a vendor sell in
a fair to recover the Rs. 800 fees paid by him for
getting a selling stall and additional cost of Rs.
400 to install the stall?
 What is the BEP sales (units)
 What is the BEP Revenue?
 What is the margin of safety at 2000 units sales?
 What is the profit at 2000 units sales?
 What % of sales can fall to reach the BEP sales?
BREAK EVEN CHART/ COST
VOLUME PROFIT (CVP
GRAPH)

 The break even chart is a graphic relationship

between volume, costs and profits.
 It shows not only the BEP but also the effects
of costs and revenue at varying levels of sales.
 It is also called as Volume-cost-profit graph
 ASSUMPTIONS OF
CVP/BREAK EVEN CHART

 Costs can be bifurated into variable and fixed components.

 Fixed costs will remain constant during the relevant volume
range of graph.
 Variable cost per unit will remain constant during the relevant
volume range of graph.
 Selling price per unit will remain constant irrespective of the
quantity sold within the relevant range of the graph.
 Production and sales volume are equal.
 There is only one product
 Volume of production equal volume of sales
 Productivity per worker does not change
 There will be no change in the general price level.
 EXAMPLE:

 Selling Price per unit Rs. 10

 Fixed Costs Rs. 60000
 Variable costs per unit Rs. 5
 Relevant Range:
 Lower Limit 6000 units
 Upper Limit 20000 units
 Break up of Variable costs:
 Direct Material Rs. 2
 Direct Labor Rs. 1.50
 Direct Expenses Rs. 1.0
 Selling Expenses Rs. 0.50
 Actual Sales, 18000 units (Rs. 18000x10 = 180000)
 Plant Capacity, 20000 units (Rs. 20000x10 =200000)
 Tax Rate : 50%.

Draw Break Even Chart and identify Break Even Point.

 Y
Relevant Area

200 e
L in
le s
180 Sa

Margin of Safety
Revenue and costs ( in’ooo rs)

r ea
160

(Rs)
fi tA
Pro
140
BEP
120 Margin of Safety Variable Cost Area
(units)
100
Line
st
Co ea
80 o tal Ar
T s s
Lo Fixed Cost Line
60

40
Upper Limit
Lower Limit

Fixed Cost Area

20

2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 x
Sales Volume (in thousand)
 Y

200 e
L in Rs. 20000 Net Income
le s
180 Sa
Rs. 20000 Income Tax
Revenue and costs ( in’ooo rs)

160 Rs. 10000 Selling Exp

Rs. 20000 Direct Exp
140
BEP

Variable Cost

Total Cost and Expenses

120 Rs. 30000 Direct Labor

100
Line
st
Co Rs. 40000 Direct
80 o tal Material
T
60

Rs. 60000 Fixed Exp

40
(Factory, Adm,
Selling)
20

2 4 6 8 10 12 14 16 18 20 x
Sales Volume (in thousand)
 ROLE OF INCOME TAXES IN CVP
ANALYSIS

Assume that the Pants Shop can purchase pants

for $32 from a local factory; other variable costs
amount to $10 per unit.
The local factory allows the Pants Shop to
return all unsold pants and receive a full $32
refund per pair of pants within one year.
The average selling price per pair of pants is $70
and total fixed costs amount to $84,000.

3 - 28
 ROLE OF INCOME TAXES IN CVP
ANALYSIS

How much revenue will the business receive if

2,500 units are sold?

2,500 × $70 = $175,000

How much variable costs will the business incur?

2,500 × $42 = $105,000

$175,000 – 105,000 – 84,000 = ($14,000)

 ROLE OF INCOME TAXES IN CVP
ANALYSIS

What is the contribution margin per unit?

$70 – $42 = $28 contribution margin per unit

What is the total contribution margin when

2,500 pairs of pants are sold?

2,500 × $28 = $70,000

What is the contribution margin percentage?

$28 ÷ $70 = 40%

3 - 30
 ROLE OF INCOME TAXES IN CVP
ANALYSIS

If the business sells 3,000 pairs of pants,

revenues will be $210,000 and
Contribution margin would equal
40% × $210,000 = $84,000.

3 - 31
 ROLE OF INCOME TAXES IN CVP
ANALYSIS

Management would like to earn

an after tax income of $35,711.

The tax rate is 30%.

What is the target operating income?

Target operating income

= Target net income ÷ (1 – tax rate)

TOI = $35,711 ÷ (1 – 0.30) = $51,016

3 - 32
 ROLE OF INCOME TAXES IN CVP
ANALYSIS

How many units must be sold?

Revenues – Variable costs – Fixed costs

= Target net income ÷ (1 – tax rate)

$70Q – $42Q – $84,000 = $35,711 ÷ 0.70

$28Q = $51,016 + $84,000

Q = $135,016 ÷ $28 = 4,822 pairs of pants

3 - 33
 ROLE OF INCOME TAXES IN CVP
ANALYSIS

Proof:
Revenues: 4,822 × $70 $337,540
Variable costs: 4,822 × $42 202,524
Contribution margin $135,016
Fixed costs 84,000
Operating income 51,016
Income taxes: $51,016 × 30% 15,305
Net income $ 35,711

3 - 34
MINI CASELET ON CVP ANALYSIS
WITH INCOME TAXES
VOLUME PROFIT CHART

 The volume profit graph portrays the relationship of

profit to volume.
 This chart supplement Break Even chart.
 V/P chart shows a direct relationship between the sales
volume and profits.
 It is a summary form of break even chart.
 It shows the profit and loss at different levels of sales.
 The horizontal axis represents the volume of sales.
 The vertical axis represent profit and loss conditions.
EXAMPLE

From the following data, draw a profit-volume

chart.
 Fixed costs Rs. 40000
 Variable costs Rs. 2 per unit
 Sales 10000 units at a price of Rs. 10 each
 PROFIT CHART

50

Profit (Rs. ‘000)

40

Line 30
Break Even Point fi t
Pro Profit 20
10
0
10 20 30 40 50 60 70 80 90 100
Loss (Rs. ‘000)

10
20 Loss
Sales (Rs. ‘000)
30
40
50
 EFFECTS OF CHANGE IN
SP,FC,VC,QTY
 Change In Qty
 If the Quantity sold/produced changes by
certain percentage, profit changes by 20%,
in the same direction.
 i.e. if there is 10% increase in qty sold,
profit increases by 20%. Vice versa.

 Change in Selling Price

 If the Selling Price changes by certain
percentage, profit changes by 40%, in the
same direction.
 i.e. if there is 10% increase in Selling Price,
profit increases by 40%Vice versa.
 EFFECTS OF CHANGE IN
SP,FC,VC,QTY
 Change In Fixed Cost
 If the FC changes by certain percentage,
profit changes by same % times, in the
Opposite direction.
 i.e. if there is 10% increase in fixed cost,
profit decrease by 10%. Vice versa.

 Change in Variable cost

 If the Variable cost changes by certain
percentage, profit changes by 20 %, in the
opposite direction.
 i.e. if there is 10% increase in Variable cost,
profit decreases by 20% . Vice versa.
THANK YOU