 Cost Volume & Profit (CVP) Analysis & Short-term

Decision Making - Revision

 Further aspects of CVP Analysis

 CVP analysis under conditions of uncertainty

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What is CVP analysis?

Cost-Volume-Profit (CVP) analysis is a

technique used to determine the effects of
changes in an organization's sales volume
on its costs, revenue and profit.
Importance of CVP Analysis
 CVP analysis usually described as a short term
decision tool.
 Common application-> Break Even Analysis
 To identify the levels of operating activity needed
to avoid losses, achieve targeted profits
 To plan future operations
 If we put up our prices, Sales volume drops, prices of our inputs
increases
 To guide Other decisions- >strategic decisions-> risks
 Choosing additional features to existing product
 If sales are 10% lower than estimated
Understanding cost behavior

 In short term decision-making understanding

cost behavior is important.
 To analyze the cost behavior, cost structure
should be known.
 Cost structure is the proportion of fixed and
variable costs to total costs.
Profit equation

 Profit = Total revenue - Total costs

 Profit = TR– (TVC + TFC)

 Profit = TR – TVC - TFC

contribution
 Profit = Contribution - TFC
• Total Contribution = Fixed cost + profit
Total contribution > fixed cost = Profit
Total contribution = fixed cost = BEP
Total contribution < fixed cost = Loss

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Contribution margin ratio
C/S ratio / P/V ratio:

The contribution margin per unit expressed as a

percentage of the selling price per unit

Contribution X 100
Sales

This ratio shows the relationship between sales

and contribution.

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Break Even Point (BEP)

 The break-even point is the level of activity where

an organization neither enjoys any profit nor incurs
any loss.
 In other words, when its Total Revenue equals
Total Cost.
 BEP is decided on how revenue and cost behave
according to the production level.
 Hence, it is clear that the break even analysis is
understanding between cost, volume and profit.
A few points to remember
 The break even value can only be calculated as an
approximate figure
 Thus, it is meaningful to express the break even
point in a range of values
 In real life situations, computation of the break
even point will have to be done with suitable
assumptions.
Foundational Assumptions in CVP

 All costs can be classified into fixed & variable

elements.

 Fixed cost will remain constant & the variable cost

vary with production levels.

 Selling price, variable cost per unit & fixed costs are
all known and constant

 Over the activity range being considered costs &

revenue behaved in a linear fashion. 10
Foundational Assumptions in CVP (cont...)

 The only factor affecting cost & revenue is volume

(i.e. changes in production/sales volume)

 The technology, production methods & efficiency

remain unchanged

 The time value of money (interest) is ignored

 There are no changes in stock levels

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 Break Even Analysis can be done in two
ways;

 Equation approach
 Graphical approach

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Equation approach to Break Even Analysis
****note

 Break Even Point (units) = Fixed Cost

Contribution per unit

Break Even Point (Rs) = Fixed Cost

C/S ratio

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Breakeven Point, extended:
Profit Planning ****note

Level of sales to achieve a target profit

 With a simple adjustment, the Breakeven Point

formula can be modified to become a Profit
Planning tool.

 Profit is now reinstated to the BE formula,

changing it to a simple sales volume equation
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Target sales (units) = Fixed costs + Target profit
Contribution margin per
unit

Target sales value (Rs) = Fixed costs + Target profit

Contribution margin ratio
Margin of Safety (MoS)

 The margin of safety is the excess of budgeted

sales over the break-even sales level.

MoS = Budgeted Sales – BE Sales

Income taxes in CVP analysis

 Target volume (units) =

Fixed costs + [Target profit / (1- t)]

Unit contribution margin
Graphical approach to CVP analysis
 when a simple overview is sufficient or
 when greater visual impact is required

 A break-even chart can be drawn in two ways.

Using traditional approach
Using contribution approach
 Activity 1
Shehan Entertainments operate in the leisure and entertainment
industry and one of its activities is to promote concerts at locations
throughout the country. The company is examining the viability of a
concert in Kandy. Estimated fixed costs are Rs.600,000. These
include the fees paid to performers, the hire of the venue and
advertising costs. Variable costs consist of the cost of pre-packed
buffet which will be provided by a firm of caterers at a price, which is
currently being negotiated, but it is likely to be in the area of Rs. 100
per ticket sold. The proposed price for the sale of a ticket is Rs.200.
Assume that the relevant range is sales volume of 4,000-12,000
tickets. (Adopted from Drury, 2007)
Using the information given above, construct the traditional break-
even chart for Shehan Entertainments. You are required to identify
BEP, profit and loss areas, relevant activity range in the graph.
Profit chart

 The profit volume chart is more convenient

method of showing the impact of changes in
volume on profits.

 Under this method of CVP analysis, only the

profit or loss line is drawn in order to identify
the break-even level.
 Activity

Using the information given in the Activity 1,

develop the Profit chart.
Profit chart and product range

 The simple break-even analysis can be extended to

cope with the multi-product situation provided the
assumption that the organization sells its products
in a constant mix.
 Steps
1. Calculate C/S ratio
2. Determine the priority ranking
3. Draw a graph according to the priority
 Activity

A firm is producing three products namely X, Y and Z. It has

a fixed cost of Rs.50,000

Product Sales (Rs.’000) Variable costs (Rs.’000)

X 150 120
Y 40 20

Z 60 35

Prepare a profit chart and calculate BEP if the company is

producing in most profitable way.
Sensitivity analysis and Uncertainty

 Sensitivity analysis is a “what-if” technique that

managers use to examine how an outcome will
change if the original predicted data are not
achieved or if an underlying assumption changes.
 “What” happens to profit “if”:
Selling price changes
Volume changes
Cost structure changes
Variable cost per unit changes
Fixed cost changes
 Another aspect of sensitivity analysis is margin of
safety, the amount by which budgeted (or
actual)revenues exceed breakeven revenues.
 The margin of safety answers the “what-if”
question: if budgeted revenues are above
breakeven and drop, how far can they fall bellow
budget before the breakeven point is reached?
 Such a fall could be a result of a competitor
introducing a better product, or poorly executed
marketing programs, and so on.
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Marginal costing and management decisions in short run

 Concept of Marginal Costing is very useful in

making managerial decisions in the short run.
Marginal costing, when a limiting factor exists

 What is a limiting factor?

 Steps:
 Ascertain the contribution
 Ascertain the contribution per limiting factor
 List the order of preferences
 Activity

A Company is producing 4 products and planning it’s production mix for

the next period. Estimated cost, sales and production data are given
below.
Product W X Y Z
Selling price per unit 20 30 40 36
Labour (2/= per hour) 6 4 14 10
Material (1/= per kg) 6 18 10 12
Maximum demand (units) 5,000 5,000 5,000 5,000

Based on the above data, what is the most appropriate mix if;
•Labour hours are limited to 50,000 hours in a period
•Materials are limited to 110,000 Kg in a period.
Acceptance of a special order

 What is a special order?

 What are the fundamental criteria to accept

or reject a special order?
 Activity

X Ltd manufacture & market a drink which they sell at

Rs.20 per bottle. Current output is 400,000 bottles per
month, which represent 80% of capacity. They have the
opportunity to utilize their surplus capacity by selling the
drink at Rs.13 per bottle to a super market, which will sell
it as an own labeled product. Total cost for the last month
was Rs.5,600,000 out of which 1,600,000 were fixed cost.

Based on the above data, write a report to the Board of

Directors stating whether to accept this special order and
the other factors that has to be considered in making the
decision.
Dropping a loss making product

 When a company is producing a range of

products, which include a product
incurring losses, business will have to
decide whether such product to be
discontinued.
 Activity

X Company has a range of products of which revenue and cost data are as
follows
X (Rs.) Y (Rs.) Z (Rs.)
Sales 32,000 50,000 45,000
Total cost 36,000 38,000 34,000

The total cost comprises of 1/3 of the fixed cost. The Marketing manager of the
Company argues that product X is making losses and hence it should be
discontinued. The Managing Director of the organization seeks your advice on
the issue.
Make or Buy Decisions

 Frequently the management is faced with

the decision whether to make a particular
product or component or whether to buy it
from outside.
 Activity

A firm manufactures component “XL 200” and the cost for the production
at current level of 50,000 units are as follows
Cost per unit (Rs.)
Raw material 2.50
Labour 1.25
Variable O/H 1.75
Fixed O/H3.50
Component “XL 200” could be bought for Rs.7.75 and if so, the production
capacity utilized at present would be unused. Decide whether “XL 200” to
be manufactured or purchased. Show the effect on profit based on your
calculations.