Cost VOLUME RELATIONS & BREAK EVEN ANALYSIS

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1. Introduction

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.

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1. Introduction

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.

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1. Introduction

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.

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1. Introduction

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.

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1. Introduction

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.

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1. Introduction

The relationship among cost, volume and profit is expressed by

a] reports or statements ; b] charts or graphs or

c] a mathematical deduction.

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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

indicate costs at various levels of activity.

c] To assist performance evaluation for

the purposes of control.

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2. Objectives of Cost Volume Profit Analysis - contd.

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.

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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.

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3. Profit – Volume 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.

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3. Profit – Volume Ratio Can be improved by :

Increasing selling price per unit.

Reducing direct and variable costs.

Switching production to products with

greater P/V ratio.

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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).

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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

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5. Methods for determining Break Even Points

♠ 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.

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5. Methods for determining Break Even Points

Illustration A – If Sales price Rs. 120 each.

Variable cost per unit Rs. 80 and annual fixed costs Rs 8,000/-

BEP = Rs. 8,000 ÷ (120 – 80)

= 200 units.

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5. Methods for determining Break Even Points 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, 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/-

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5. Methods for determining Break Even Points

♠ 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.

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5. Methods for determining Break Even Points

♠ Break-even Chart : Assumptions :

1. Costs are bifurcated into fixed &

variable.

2. Fixed costs will not change with change in levels of output.

3. Variable cost per unit will remain

constant.

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5. Methods for determining Break Even Points

♠ Break-even Chart : Assumptions :

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.

7. In case of multi product company, sales

mix remains unchanged.

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5. Methods for determining Break Even Points Break-even Chart :

Sales

BE Point Profit

Sales

Variable Cost

&

Cost

^{Fixed Cost}

Loss

0 Units

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5. Methods for determining Break Even Points

Break-even Chart : alternate method Sales Profit

Sales

BE Point Total Cost

&

Variable Cost

Cost Loss

0 Units

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5. Methods for determining Break Even Points

♠ Contribution Break-even Chart :

Sales

&

^BEP Contribution

Cost

Fixed Cost

0 Units

When total contribution = Fixed cost

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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 adequate, else little fall in sales

activity can prove disastrous. ( as firm

will incur loss).

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6. Margin of Safety

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.

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6. Margin of Safety

Steps to improve margin of safety.

9 Lower fixed costs.

9 Lower variable cost and thereby contribution.

9 Increase sales activity & utilize full capacity.

9 Increase sales price per unit.

9 Improve contribution by optimizing

product mix.

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7. Practical Application of Profit –volume Ratio

Problems where profit-volume ratio can be used gainfully –

√ ascertain profit at particular level of sales.

√ determine break-even point.

√ calculate sales required to achieve desired profit.

√ compare relative profitability of a]

product lines, b] sales area, c] methods

of sale, d] companies & e] businesses.

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8. Other Uses of CVP Analysis

√ Forecast cost & profits as a result of change in volume.

√ Effect of change in volume due to plant expansion.

√ Determine relative profitability of

each product, line, project or profit

plan.

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8. Other Uses of CVP Analysis - contd

√ Allows intelligent inter-firm comparison of profitability.

√ Determine cash requirements at

different levels of output using cash break even charts.

√ Determine profit potentialities, requirements of capital, financial stability, and incidence of fixed &

variable costs.

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