Summary Chapter Five
Cost Volume Relations & Break Even Analysis
1. Introduction :
The main aim of an undertaking is to earn profit.
The cost volume profit (CVP) analysis helps management in finding out the relationship of costs and revenues to profit.
Cost depends on various factors like Volume of production
Product mix
Internal efficiency Methods of production
Size of plant; etc.
The cost volume profit (CVP) analysis furnishes a picture of the profit at various levels of activity. From this management identifies effects of changes in
sales volume,
price or
costs upon profits.
The cost volume profit (CVP) relationship is determined by distinguishing fixed and variable costs and then depicting in a form of chart how changes in output affect them.
For volume changes within the capacity fixed costs do not change with variation in output volume.
Fixed cost per unit decreases as volume increases.
Full costing system seeks to allocate the fixed costs to products and create problems of apportionment as these costs as stated above have little relationship with output
The variable cost is constant per unit of production as it varies with volume.
Volume is expressed as a % of sales capacity or a % of production capacity or in number of production units or some times in labour or machine hours.
The relationship among cost, volume and profit is expressed by
a] reports or statements ; b] charts or graphs or
c] a mathematical deduction.
2. Objectives of Cost Volume Profit Analysis
a] To know relationships between profit and costs on one hand & volume on the other.
b] To set up flexible budgets that indicates costs at various levels of activity.
c] To assist performance evaluation for the purposes of control.
d] To review profit achieved and costs incurred, evaluate effects on costs of changes in volume.
e] Pricing plays an important part in stabilizing and fixing up volumes.
Cost Volume Profit Analysis assists formulation of pricing policies.
3. Profit – Volume Ratio
The ratio or percentage of contribution margin to sales is known as P/V ratio.
It is also known as
marginal income ratio;
contribution to sales ratio;
variable profit ratio.
Equations :
Sales – Variable Cost = Contribution.
Contribution
P/V ratio = Sales or
sales value – variable cost
sales value
Fixed Cost + Profit or
Sales Value
or Change in Profits ÷ Contribution.
Products with higher P/V ratio are profitable.
P/V ratio can be improved by :
• Increasing selling price per unit.
• Reducing direct and variable costs.
• Switching production to products with greater P/V ratio.
4. Break Even Analysis
The categorization of costs into ‘variable’ and
‘fixed’ elements and their relationship with sales and profits has been developed as ‘break-even analysis’. It plays a major role in managerial decisions including profit planning. Break-even is the point where total revenues equal the total costs (fixed plus variable).
Below the break even point (BEP) revenues are unable to cover the costs and firm incurs losses.
Only when actual sales are greater, than the level indicated by the BEP, that the firm starts earning profit.
5. Methods for determining Break Even Points
♠ Algebraic Methods :
a] Contribution Margin Approach.
b] Equation Techniques.
♠ Graphic Presentation:
a] Break-even Chart b] Profit Volume Chart
Algebraic Methods :
a] Contribution Margin Approach.
Break-even points (BEP) units =
Total Fixed Costs
(Selling Price per unit – Marginal Cost per unit.
Or
Total fixed cost ÷ Contribution per unit.
Illustration A –
A product is sold at a sales price Rs. 120/- per unit and its variable cost Rs. 80/- per unit. The fixed expenses of the business are Rs 8,000/- per year.
Find i] BEP in Rs. and units.
ii] Sales required to earn a profit of Rs.
8,000/- a year.
BEP = Rs. 8,000 ÷ (120 – 80) = 200 units.
or 200 x 120 = Rs 24,000/-
To calculate the level of sales required to earn a particular profit, the formula is
Required Sales = (Fixed Cost + Desired Profit)
÷ P/V Ratio
Using earlier Illustration A,
ii] required sales to earn a profit of Rs. 5,000/- P/V Ratio = 80 ÷ 120 = 33⅓ %
Required Sales = (8,000 + 5,000) ÷ 33⅓ % = Rs. 39,000/-
Break-even Chart :
It is a chart that shows profit or loss at various levels activity. The level at which there is neither profit nor loss is termed as break-even point.
Assumptions :
1. Costs are bifurcated into fixed & variable portions.
2. Fixed costs will not change with change in levels of output.
3. Variable cost per unit will remain constant as they vary in proportion to change in volumes.
4. Selling price remains unchanged at various level of activity.
5. The number of units produced and sold is the same & there are no opening / closing stocks.
6. Operating efficiency is constant (economies of scale absent).
7. In case of multi product company, sales mix remains unchanged.
Break-even Chart : a typical method.
Sales
BE Point
Sales
Profit&
Cost
Variable CostFixed Cost
Loss
0 Units
Break-even Chart: alternate method
Sales
Profit
Sales
BE Point Total Cost
&
Variable Cost
Cost
Loss
0 Units
Here Break-Even point is indicated where total contribution equals total Fixed Cost; and thus there is no profit no loss.
♠ Contribution Break-even Chart :
Sales
Sales
&
BEPContribution
Cost
Fixed Cost
0 Units
6. Margin of Safety
Margin of safety is the difference between actual sale and sales at the break even point.
Management ensures that margin of safety is always adequate, else little fall in sales activity can prove disastrous (as firm will incur loss).
Margin of safety is also calculated using P/V ratio.
Margin of Safety = Profit ÷ P/V ratio.
Margin of safety can be measured in absolute terms as Rs ---- or as a % of sales i.e.
(Margin of Safety ÷ Total Sales) x 100.
Steps to improve margin of safety.
9 Lower fixed costs.
9 Lower variable cost and thereby increase contribution.
9 Increase sales activity & utilize fully available capacity.
9 Increase sales price per unit.
9 Improve contribution by optimizing product mix.
7. Practical Application of Profit –volume Ratio Problems where profit-volume ratio can be used gainfully.
1. To ascertain profit at particular level of sales.
2. To determine break-even point.
3. To calculate sales required to achieve desired profit.
4. To compare relative profitability of a] product lines,
b] sales area,
c] methods of sale,
d] two or more companies &
e] two or more businesses.
8. Other Uses of CVP Analysis
1. To forecast cost & profits as a result of change in volume.
2. To measure effect of change in volume due to plant expansion.
3. To determine relative profitability of each product, line, project or profit plan
4 Allows intelligent inter-firm comparison of profitability.
5. Determine cash requirements at different levels of output using cash break even charts.
6. Determine profit potentialities, requirements of capital, financial stability, and incidence of fixed & variable costs.
9. Advantages of Break-Even Charts
1. Data is depicted in simple & clear terms.
2. Besides the level at which there is no profit no loss, profitability of different products is known from the chart.
3. Effects of change in volume on costs shown graphically for understanding by all employees.
4. The role played by Fixed Costs in profits is highlighted.
To sum up, break-even analysis provides data for analysis of economies of scale, capacity utilization, comparative plant efficiencies etc.
Break-even analysis is a very helpful tool for forecasting, long-term planning, growth &
stability.
10. Limitations of Break-Even Analysis
• Fixed costs do not always remain constant.
• Variable costs do not always vary proportionately and unit variable cost does not
remain constant.
• Sales revenue does not always vary proportionately.
• Firm sells many unlike products in the market.
• Ignores quantity produced and held in opening or closing stocks.
• Ignores continuous change in growth & expansion of an organization.
• Limited data can be presented in a single chart.
• Identical data can be presented by other tabulations.
In spite of all these limitations break even analysis has wide application as a quick and generalized technique in cost – volume – profit relationship.
