Cost-Volume-Profit Analysis

13-June-2014

Objectives State the application areas and assumptions underlying the use

of marginal costing;

Use cost volume profit analysis to determine the breakeven point and margin of safety;

State the effect of cost structure on decisions;

Apply cost volume profit analysis in profit planning;

Carry out sensitivity analysis of the changes in the parameters;

Present profitability statement based on absorption costing and marginal costing;

Explain the importance of use of marginal costing for internal reporting;

Distinguish between absorption costing and marginal costing.

CVP Equation Total cost = fixed costs + (units sold x unit variable

cost/unit) Profit = Sales Fixed costs Variable costs

Sales = Units sold x Selling Price Variable costs = Units sold x Variable cost per unit P = S F - V

Profit + Fixed costs = Sales Variable costs P + F + S V

Contribution = Profit + Fixed costs C = P + F

Contribution = Sales Variable costs C = S - V

Marginal Costing: Application Areas

1. Planning

2. Control

3. Decision Making: a. Maximization of contribution

b. Determination of break-even point

c. Determination of Margin of Safety

d. Pricing decisions

e. Product substitution and discontinuance

f. Acceptance of offer or submission of tenders

g. Make or buy decisions

Break Even Point (BEP)

Break-even Point: Break even point is the level of activity or sales where the total sales are equal to total costs or where the contribution is equal to total fixed costs or where the firm makes no profit or no loss.

RatioPV

FixedCostSalesValue

UnitonContributi

FixedCostSalesUnit

/

Improving Break Even Point

Increasing the selling price of the product;

Decreasing the variable cost of the product;

Selecting a product mix containing larger PV ratio items of products;

Reducing the fixed costs.

Margin of Safety

Margin of safety is the excess of sales over the break even sales which may be in terms of number of units or sales value.

Margin of safety = Total sales units Break-even sales units,

or Total sales value Break even sales value

Improving Margin of Safety

Increasing the selling price of the product;

Decreasing the variable cost of the product;

Selecting a product mix containing larger PV ratio items of products;

Reducing the fixed costs;

Increasing the number of units (volume of production).

Four Conditions of Business

Low break-even point and large angle of intersection,

High break even point and large angle of intersection,

Low break-even point and small angle of intersection,

High break-even point and small angle of intersection,

Sensitivity Analysis Cost Element Change PV Ratio Break-even

Point Margin of Safety

Selling Price Increase Increase Decrease Increase

Decrease Decrease Increase Decrease

Variable Cost Increase Decrease Increase Decrease

Decrease Increase Decrease Increase

Fixed Costs Increase

No Change Increase Decrease

Decrease No Change Decrease Increase

Volume of Output

Increase Decrease

No Change No Change

No Change No Change

Increase Decrease

Profit Planning

Determination of appropriate production volume, selling price and levels of

fixed costs required to earn the desired profit.

Determination of the break even point to examine the feasibility of achieving

the goal.

Which product should be selected for manufacture and in the case of multi-

product companies determination of optimal product mix is important.

Conducting sensitivity analysis to study the impact of changes in the selling

price, costs and volume on the desired profit.

Analysis of the discretionary costs with a view to exploring the possibility of

minimizing them to reduce the overall fixed costs to improve the margin of

safety.

Cost Indifferent Point and Break-even Point

Cost Indifference Point

Cost indifference point is obtained by dividing the difference in fixed costs of the two alternatives by the difference in the variable cost of the two alternatives.

Cost indifference point indicates the output at which the decision maker is indifferent in choice between the two alternatives.

After crossing the cost indifference point, the decision is changed from lower fixed cost proposal to higher fixed cost proposal.

The decision maker can accept one of the proposals even below indifference point.

Break-even Point

The break even point is obtained by dividing the total fixed costs by contribution per unit that is selling price minus variable cost, per unit.

The break even point is the minimum quantity of output which is required to be produced to meet all the costs.

After crossing the break-even point, the company starts making profit.

The decision maker does not accept any proposal below break-even point as it will lead him to loss.

Marginal Costing: Assumptions

Only one variable can be changed at a time.

The company produces a single product.

Fixed costs are constant.

Contribution concept is used in determining profit.

Unit variable costs and selling prices are constant per unit.

CVP analysis applies in a relevant range.

Costs are segregated correctly in to fixed and variable.

CVP analysis is applicable in a short term horizon.

Productivity and efficiency remain constant.

Capital investment in business is not considered.

Break Even Analysis: Limitations

The presence of step cost may lead to multiple break-even points.

The variable costs may not always be constant per unit because of the effect of price discounts due to bulk buying and learning curve applications on labour costs.

The selling price may not always be constant per unit because of discounts granted to the bulk orders.

The product mix may change depending on the market demand and consumer preferences.

Marginal Costing and Absorption Costing

Marginal Costing

1. The unit product cost represents all variable costs.

2. The cost per unit is constant and varies in direct proportion to output.

3. Contribution is obtained by deducting variable costs from sales.

4. Stocks are valued at variable production cost.

5. The fixed costs stand charged off to profit and loss account.

6. Profit is correctly stated.

7. Fluctuations in the volume of opening and closing stock will not lead to stock profit or loss.

Absorption Costing 1. The unit product costs represent production variable and production fixed costs.

2. The cost per unit varies in inverse ratio to the output.

3. Profit is represented by sales minus total costs.

4. Stocks are valued at production variable cost plus production fixed cost.

5. A proportionate amount of production fixed costs enters in to the value of stocks.

6. Profit and loss account is vitiated and the profits are not correctly stated.

7. Fluctuations in the volume of opening and closing stocks will lead to stock profit or loss.

Some Other Resources

CVP Analysis Online:

https://cb.hbsp.harvard.edu/cbmp/trials/37660958

Manage Customers for Profits (Not Just Sales), Harvard Business Review,

Sept.-Oct.1987.

https://hbr.org/1987/09/manage-customers-for-profits-not-just-sales